From personal, educational, mortgage and more, debt defines the finances of Americans like nothing else. American households hold almost 15 trillion dollars of debt.
One reason why that number is so high is that there are many types of personal debt. Many people confuse them together, but each one has distinctions that can impact your finances.
What is a secured debt, and how does it compare to an unsecured debt? What is revolving debt? What exactly are mortgages?
Answer these questions and you can take out the right types of loans that will ensure your financial stability. Here is your quick guide.
Secured Debt
A secured debt is a debt that is backed with an asset. If the borrower fails to pay the lender back, the lender will seize the asset.
Car and home loans are classic examples of secured debts. People take out money to buy a car, and the lender can seize the car if they don’t get their money in time.
The threat of seizing an asset motivates borrowers to pay their debt off. But lenders often attach high-interest rates and other qualifications to their arrangements to motivate the borrower to pay them.
This makes secured debts very risky for borrowers. One missed payment can result in them losing an asset.
They should have strong personal finances and a clear payment schedule so they never miss a payment. The asset should be something they can afford to lose, not their primary residence or means of transportation.
Unsecured Debt
An unsecured debt is a debt that does not have an asset backing it. If the borrower fails to pay the lender back, there may be no immediate consequences.
This does not mean that the lender is powerless. They can get away with charging very high interest rates, and they can file lawsuits if they never get paid back.
An unsecured debt adds up very quickly. The lack of motivation that lenders have to pay their borrowers back may mean that they postpone payments. This can result in them paying tens of thousands of dollars once interest rates add up.
Lenders are very reluctant to make unsecured debt arrangements. They check the background information of a potential borrower, seeing what their credit history is like. People with weak financial security will get denied arrangements.
Revolving Debt
Revolving debt allows a consumer to borrow money on a regular basis. They can borrow up to a certain limit every week or month. They must pay the money back at some point in order to continue borrowing.
Some revolving debt arrangements require minimum payments every month. This may leave some money unpaid, which may be prone to interest rates. Others mandate that the debtor pay off all of their debt before the next month.
Credit card debt is a type of revolving debt. When someone pays for something with a credit card, they are borrowing money from the credit card company. This expense must be paid back, or the company can cancel the arrangement.
Most credit card companies will open accounts with anyone. Most forms of revolving debt are unsecured, though they may impact a person’s credit rating. If the rating drops by too much, the arrangement may end.
Nonrevolving Debt
Nonrevolving debt offers a line of credit that a person cannot use more than once. The borrower takes a certain amount of money and uses it for some purpose. They then must make installments to pay the money back in a certain time period.
Student loans are classic examples of nonrevolving debt. A student goes to a bank and receives money to pay their college expenses. After college, they must write checks every month to pay the loans back.
Interest is a critical factor in nonrevolving debt. Some lenders may craft a long-term payment schedule, requiring the borrower to pay off over years. But that schedule may require high payments because interest rates build up through time.
A Plenti debt consolidation loan is another example of a nonrevolving debt. It allows you to borrow money in order to pay off your other debts.
Mortgages
In broad strokes, mortgages are secured debts. If a borrower fails to pay back their lender, the lender can seize the borrower’s house. But mortgages are often more complicated than that.
Most mortgage schedules require installments over a very long period of time. Someone may be paying off their mortgage 30 years after they buy their house. On rare occasions, lenders may allow borrowers to make two payments a month.
Interest rates tend to be low. Some arrangements involve an adjustable-rate mortgage, meaning interest rates can change depending on how the economy is doing.
Interest rates are tax-deductible, usually at a one-to-one ratio. This makes mortgages more affordable, though the cap for tax deductibility is one million dollars. Very expensive homes will exceed that cap after a few years of payments.
But taking out a mortgage can help a person’s credit score through time. Reliable on-time payments make a borrower seem responsible and credible. It also adds diversity to their financial and credit portfolios.
The Main Types of Personal Debt
You deserve to know about all types of personal debt. A secured debt is backed with an asset, like a house or car. Failing to pay back the debt means the asset is repossessed.
An unsecured debt has no asset, but it can have substantial interest. A revolving debt lets a consumer borrow money frequently, while a non-revolving debt is a one-time amount.
Mortgages are specialized kinds of secured debts. They run for long periods of time, but they have tax-deductible components.