Debt 101: What Is Debt?
Headlines abound about how today’s millennials are saddled with debt — $1 trillion to be exact. Many are resorting to moving in with their parents or having roommates for longer than expected because their debt is such a burden.
Although the term debt is used extensively in the news and in popular culture, you might be wondering what it actually means.
Debt is defined as money someone owes to another party. Debt can take many forms, from student loans and credit cards to auto loans and utility bills. Being in debt means you owe money, but the concept is more nuanced than that. There are countless types of debt, and not all debt is considered “bad.”
Below, we’ve broken down four major things you should know about debt.
4 must-know facts about debt
The term debt can often feel like it has a negative connotation. After all, nobody wants to owe money to someone else. Outstanding consumer debt in the U.S. topped $4 trillion for the first time, the Federal Reserve reported in February. But the reality is that not all debt is considered bad.
These are the four most important things you should know about debt.
1. There are different types of debt
When it comes to understanding debt, there are two different forms of it: unsecured and secured.
If a loan is secured, that means it is backed by a form of collateral. If you do not pay back the loan, you will lose whatever you have as collateral. For example, if you don’t pay your mortgage, you risk losing your home. If you don’t pay your auto loan, you risk having your car repossessed.
The following are all examples of secured debt:
- Mortgages: These are taken out to finance a home purchase. It’s important to factor in how much you can afford before taking out a mortgage.
- Home equity loans and home equity lines of credit (HELOCs): With these, homeowners can borrow against the equity they have in their home to finance a large expense.
- Auto loans: Many consumers take out auto loans to finance the purchase of a car. You can get an auto loan through a dealership, as well as a bank, credit union or online lender.
- Title loans: Title loans allow a consumer to borrow against the value of their vehicle using the car’s title as collateral.
- Secured personal loans: Some personal loans, which can be taken out to finance large expenses, are secured. This means that the borrower puts up their personal savings or stocks as collateral.
- 401(k) loans: 401(k) loans involve borrowing against one’s retirement savings. If you don’t repay the loan, you risk losing everything you’ve saved for retirement.
Common forms of unsecured debt are student loans and credit cards.
Unsecured debt is debt that isn’t backed by any form of collateral. If an unsecured debt isn’t repaid, you don’t risk losing your home, car or any other assets. Instead, the creditor — which is the party you’re borrowing against — will either try to collect the debt or send it to a collections agency, which is a third party that will attempt to collect the debt from you on the creditor’s behalf.
The following are all examples of unsecured debt:
- Personal loans: Personal loans can be taken out to finance a large expense, such as a medical bill or a home renovation project. Although some are secured by one’s personal assets, most are unsecured.
- Credit cards: Credit cards are a form of unsecured debt.
- Payday loans: Payday loans are short-term loans, typically under $500, that are designed to give consumers quick access to cash until their next paycheck.
- Student loans: Student loans are taken out to finance one’s college or advanced degree education. You can get them through the federal government or private lenders.
- Medical bills: Medical bills are also considered a form of unsecured debt.
- Utility bills: Unpaid utility bills, such as electric and gas, are unsecured debts. It’s important to know that there are ways to lower your monthly bills.
2. Not all debt is bad
Not all debt is considered bad. There are forms of good and bad debt. But how do you know which forms of debt are good and which are not?
It all comes down to how that debt is used. For example, mortgages and student loans are often considered good forms of debt. One allows you to become a homeowner, while the other allows you to finance your education. The interest rate on mortgages and student loans is often quite low.
But payday loans and title loans are often considered bad forms of debt. They are short-term, quick fixes that can often be difficult for consumers to repay on time, and they come with very high interest rates. Also, 401(k) loans are often considered a bad form of debt since you’re putting your retirement, which is something you’ve likely spent decades saving for, on the line.
Credit card debt straddles the line between good and bad. If you pay your credit card balance on time each month, it can be considered a good form of debt. It can help you build your credit, which is how future lenders will assess your trustworthiness as a borrower.
But if you don’t pay your credit card balance each month and you rack up thousands of dollars in credit card debt, it is considered a bad form of debt since the interest rates that accompany credit cards are often quite high.
3. Your debt repayment activity is tracked on your credit report
It can be tempting to let a monthly credit card payment or student loan payment slip through the cracks. But failing to repay your debt diligently is something that can have a lasting adverse effect on your finances.
You might be familiar with the terms credit report and credit score. A credit report is a detailed account of your financial picture. Besides basic information like your name and Social Security number, a credit report includes information on your current loans and any outstanding balances.
Also, a credit report includes a history of your previous payments, with any late payments reported. Credit reports are checked by prospective lenders, so having a track record of missed payments can be detrimental if you’re attempting to borrow money, such as a mortgage or car loan.
Credit scores are determined by the information in your credit report. Credit scores range from 300 to 850, with a score of 700 or above generally considered good. You can check your credit score for free through LendingTree and your credit report once a year from the three main credit reporting bureaus at AnnualCreditReport.com.
4. There are various strategies for paying off debt
If you hold significant debt and are struggling to keep everything organized, there are different strategies you can use to pay off your debt:
- Debt management plan: One way to repay debt is by working with a nonprofit credit counseling agency. These agencies can help you come up with a simple, streamlined repayment plan called a debt management plan. You will make one monthly payment to the agency, which will then disburse the payment to your various creditors.
- Debt consolidation: If you hold a significant amount of credit card debt, debt consolidation could be worth considering. Debt consolidation involves combining all your debt and taking out a personal loan that will go toward paying off that debt each month.
- Debt settlement: Debt settlement involves working with a debt relief firm that will negotiate your debts with your creditors on your behalf. Because debt settlement is an industry that is rife with scams, it is wise to proceed with caution if you pursue this path. Know that debt settlement may have a lasting negative impact on your credit report.
- Bankruptcy: If you hold a substantial amount of debt that you don’t expect ever being able to repay, bankruptcy might be an option. Like debt settlement, bankruptcy will be very damaging to your credit report, and can often take 10 years from which to recover.
The bottom line
If you’re on the journey to becoming debt-free, the most important thing is to be educated. By learning about what debt is, the various forms of debt and what is considered good and bad debt, you’ve taken the first step toward financial freedom.