What is Debt?

Debt is the obligation to pay money (or other agreed value) to another party, such as you borrowing money from your brother to buy a car. The one that owes the debt is called the Debtor, you in the example. The one to which the debt is owed is called the Creditor, your brother in the example. Debt can either be used to generate value and increase your net worth or it can be a weight upon you if misused. Knowing the proper way to handle debt can be different from being financially grounded or drowning.

In the next section, we will discuss some of the more common types of Debt. We will also show how these types of debts can be used properly to be financially grounded or misused to cause anxiety and regret.

Table of Contents

Secured and Unsecured

With secured debt, there is an asset that is used as collateral for the debt, such as the car in the example. Thus the debt is secured by the asset. If the debt is not paid then the creditor will take the asset to cover the amount of the debt remaining.

With unsecured debt, there is not an asset attached to the debt. This is the most common type of debt. The most common example of this would be credit card debt. If the debt is not paid, there is no asset to cover the amount of debt remaining. The creditor is likely to send the debt to a debt collector, who may then sue you for the balance plus fines/fees.

Let’s get into the details of the sub-types of debt that belong to each type.

SECURED DEBT SUB-TYPES

Mortgage

When you buy real estate, whether it is for your residence, a vacation property, or an investment, you must pay the owner of the property the price of the real estate in full. This can either be done by paying cash for the real estate or by taking out a mortgage from a financial institution such as a bank or a credit union. The amount of money borrowed in the mortgage goes to the owner of the property to purchase plus any fees and/or commissions owed to agents if they were involved in the transaction. You are then left with a mortgage to the financial institution that will be paid off over a set term, typically 15 or 30 years, although there are longer and shorter terms also.

The mortgage can be either a fixed-rate mortgage or an adjustable-rate mortgage (ARM).

Fixed-Rate

In a fixed-rate mortgage, the Debtor (borrower) pays the same interest rate for the life of the mortgage. This type of mortgage stabilizes the payment somewhat. If interest rates go up, your mortgage payment (principal and interest) does not change. If interest rates go down, you may be able to refinance to take advantage of the lower rates to lower your mortgage payment.

Adjustable-Rate

With an adjustable-rate mortgage (ARM) the mortgage payment adjusts up or down as interest rates move up or down. This type of mortgage can be appealing in the short term as it can be more affordable. If interest rates rise though, you may find that you can’t afford the mortgage payment at the higher rate. This type of mortgage does not offer the stabilization that a fixed-rate mortgage does.

Auto Loans

Similar to a mortgage, when you buy a vehicle, the seller must be paid in full before you can take possession of it. If you don’t have the cash to cover the agreed-on price, then the amount due will be covered by an auto loan. Auto loans are for a set term and a set interest rate. The interest rate you are able to qualify for depends on your credit rating. The better your credit rating, the lower the interest rate. The lower your credit rating, the higher the interest rate. The most common term for an auto loan is 60 months (5 years), but there are options for shorter and longer-term loans.

Home Equity Loans

A Home Equity Loan is taken out based on the amount of equity you have in your home. The equity of your home is the appraised value minus any outstanding debt(s) against the property. A home equity loan is considered to be a second mortgage on the property because it is secured by the property. You must have at least 20% equity in your home to qualify for a home equity loan.

UNSECURED DEBT SUB-TYPES

Credit Cards

Credit card debt is accumulated by not paying off the balance from the billing cycle each month. If you charge more on your credit card than you pay off each month, you will go deeper and deeper into debt. Also, when the entire balance is not paid off each month, the credit card account accumulates interest based on the unpaid balance from the previous billing cycle, in the form of a fee. The unpaid balance then grows by this fee amount. This is how the cycle begins.

The reason you might purchase an item or service with a credit card is the ability to defer the payment or spread out the payoff over an extended period. Some credit cards, especially retail store credit cards, have zero percent interest for a term to entice you into using the store’s financing to make the purchase.

Why bother with saving up for that new grill from the home improvement store, when you can have it today? If you use the store’s credit card, there will be no interest for 90 days. You’ll pay it off in less than 90 days, no problem, right? Beware, if you don’t pay off the full amount in the no-interest term period, you will be charged the interest on the full purchase amount backdated to when the purchase was initially made. Sneaky.

Let’s say your buy the grill indicated above for $900, with no interest for 90 days, after which you will have an annual percentage rate (APR) of 18.99%. You say to yourself that you can easily pay off the grill in 3 months. That’s only $300 per month, then done. You get to the end of the 90 days only having paid $400 on the grill. Now the store credit card’s interest and backdated application of interest comes into play. You initially owed $900. After paying $400 you should have an unpaid balance of $500. Wait, with the unpaid balance triggering the backdated interest, your actual unpaid balance is $542.73.

Earning interest on store credit cards is a large percentage of most retail stores’ income. In 2017, Macy’s credit cards made up 39% of their total profit. The total profile for Macy’s in 2017 was $1.9 billion.[1] That’s $741 million from store credit card interest alone.

Student Loans

With the cost of attending college or university continuing to rise each year, more and more students, and their parent(s), are taking out student loans to pay for some, most, or all of the cost. Over the past 30 years, the average cost to attend a four-year school has nearly tripled.[2]

Over half of the students (current and past) used student loans to pay for some portion of their education. As of 2020, there was $1.57 trillion in student loan debt in the United States. Student loans, unlike most other forms of debt, can not be removed with bankruptcy.

Depending on what degree you obtain from school, some of all of the student loans may be forgiven. Examples of this are teachers and doctors who service in low-income areas. There are many student loan forgiveness programs so be sure to investigate them. See this article in Forbes for more information.

Medical Bills

A trip to the emergency room or an extended stay in the hospital can result in thousands or tens of thousands in medical bills. If you have medical insurance, then a portion may be covered, leaving you with out-of-pocket deductibles. Medical insurance may not cover everything and you’ll be responsible for paying the remainder. If you don’t have medical insurance, then you’ll be responsible for the entire amount.

If the bill(s) aren’t paid in a timely fashion or if payment plans are not set up, these unpaid medical bills may end up in collections. Debts in collections negatively impact your credit score and usually have high interest rates and penalties attached to them.

Signature Loans

A signature loan is granted by a bank, credit union, or other financial institution. No collateral is required for a signature loan. The interest rate on a signature loan is determined by your income and credit history. Signature loans are typically given for amounts ranging from $500 to $50,000 over a repayment term of 5 to 10 years.

Lines of Credit

A line of credit is created with a bank, credit union, or other financial institution that can be drawn upon as needed. The terms of the line of credit may be that the loan is to be repaid immediately or over a term. Interest on a line of credit is charged immediately upon drawing money from it.

Court Judgments

A court judgment comes as a result of a lawsuit. Once a judgment is rendered, a debt collector will take over the collection of the amount due using tools such as wage garnishment. The lawsuit that was filed against you started as an unpaid debt that you had, which then went to collections from whichever institute you initially owed. The debt collector sued you for the unpaid balance plus and penalties and fees.

Owed Taxes

Owed taxes or tax debt is money owed to a taxing authority that is past its initial due date. The taxing authority can the Internal Revenue Service (IRS), the local appraisal district, or state taxing entities.

The penalties for tax debt are among the highest allowed. They can include garnishment of wages, loss of property, taking of other tax refunds to pay.

Conclusion

As you can see there are many different types of debt. Debt can be used as a tool to help you, but if used unwisely, debt can be an anchor around your neck, holding you back.

What other types of debt do you have and how is it impacting your life, either positively or negatively? I look forward to hearing what you have to say in the comments.

What You Need to Know About Debt