Debt 101: What Is Debt?
Debt is money that is owed by one party to another. There are many different kinds of debt, and not all debt is bad. Debt that’s used responsibly can help you build your credit history and reach financial milestones like purchasing a house or a car.
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What is debt?
Debt is money loaned from one party to another with the intention of repayment. Debt can be used to cover costly expenses that the borrower might not be able to make otherwise, such as paying for college tuition. Most debt agreements accrue interest — which is your cost of borrowing.
Statistics on debt
As a result of increasing interest rates and inflation, Americans saw an 8.3% year-over-year increase in debt during the third quarter of 2022. In total, Americans owe $16.51 trillion in household debt.
The largest debt category is mortgage debt. In December 2022, California led the way with the highest average mortgage debt at $161,562.
Overall, however, these states had the highest average amount of non-mortgage debt per person:
- Georgia: $45,778
- Maryland: $45,663
- Texas: $44,850
Types of debt
Debt can be broken down into four primary types: secured, unsecured, revolving and installment. The type of debt can impact the annual percentage rate (APR) and minimum monthly payment, as well as the consequences you may face for not repaying your debt.
Secured debt is backed by collateral, typically an asset like a car, house or savings in a bank account. Auto loans and mortgages are common types of secured debt. If you fail to pay your debt, the lender can seize your collateral to recoup their losses. In the case of a mortgage, not paying your secured debt could result in a foreclosure, just as failing to repay your auto loan could result in repossession of your car.
Unsecured debt is not backed by an asset. Common types of unsecured debt are credit cards and personal loans. If you become delinquent on these debts, there are no assets for the bank to seize; however, the lender or card issuer may send your debt to a collector, who will try to recover the money, and may potentially sue for payment. While your assets won’t be seized, your credit score will take a major hit if you default on unsecured debt.
With revolving debt, borrowers are offered a set amount of money to borrow against, known as a line of credit. Borrowers only pay interest on the amount they’ve borrowed, and as they pay it off, they can borrow more. Interest rates are typically variable. The most common forms of revolving debt are credit cards, personal lines of credit and home equity lines of credit.
With installment debt, on the other hand, borrowers receive a lump sum instead of a revolving credit line. Interest rates are typically fixed on installment debt, so minimum payments remain the same each month. Personal loans and mortgages are the most common types of installment debt.
Common forms of debt
Consumers borrow money to accomplish a wide range of personal goals, from buying houses to consolidating other debt. The most common types of debt are mortgages, credit cards, auto loans, student loans and personal loans.
A mortgage loan is used to purchase real estate. By far, mortgage debt is the largest debt on average for American households. Mortgages can come with fixed or variable interest rates and are a form of secured debt. The most common form of mortgages are 30-year fixed-rate mortgages, though mortgages can come in many different forms.
Student loan debt
Student loans can help borrowers reach their career and educational goals. Workers with college degrees tend to have higher incomes and lower rates of unemployment, meaning that getting an education can be a good investment in your future. There are two different types of student loans: federal student loans and private student loans.
Americans owe a whopping $1.76 trillion in student loan debt. In 2021, more than half of all undergraduate students took out student loans to pay for college, with the average graduate borrowing $29,100.
Credit card debt
Credit cards give consumers the power to make purchases and earn rewards, but credit card debt can be costly when you’re only making the minimum payment. This form of credit typically comes with variable interest rates, and the debt is unsecured.
Americans owed about $925 billion in credit card debt in the third quarter of 2022, which is up $38 million from the start of the year.
The average APR on all current credit card accounts is 19.07%. High interest rates can make credit cards an expensive way to borrow money if you don’t repay your balance in full each month, but in the second quarter of 2022, 53% of credit card accounts carried a balance from month to month.
Auto loan debt
Auto loans give consumers the power to purchase cars. Auto loan debt isn’t inherently bad, but cars depreciate in value quickly.
On average, Americans paid $700 per month for auto loans on new cars in 2022, up 13% from the previous year. Used cars were a bit more affordable, with an average monthly payment of $525, but that’s still 11% higher than the year before. Auto loan debt is the third-largest consumer debt category, behind only mortgages and student loans.
With the rising cost of cars, borrowers are taking out longer car loans than ever before. In fact, the average auto loan term for a new car was 69.7 months in late 2022. It’s wise to avoid long-term auto loans when possible, as they take longer to pay off and will cost more in interest, all while the car is depreciating in value.
Personal loan debt
A personal loan is an unsecured loan that can be used to pay for virtually anything. Since this type of financing is unsecured, it may come with higher APRs than secured financing. Lenders rely heavily on factors like your credit score and debt-to-income ratio to determine personal loan eligibility and terms.
Americans collectively owe around $210 billion in personal loans, a number that has more than doubled since 2016. The average balance on new personal loan originations is also growing, reaching almost $8,000 in the third quarter of 2022. The majority of borrowers use these funds to consolidate debt or refinance credit cards, but many consumers also use personal loans to fund home improvements or cover medical expenses.
Like individual borrowers, small businesses have access to loans and credit cards. However, they can also use funding from sources individual borrowers can’t access, such as bonds and commercial paper.
Bonds are among the most common forms of business debt. When it comes to this type of debt, the business acts as the borrower while the investors are the lenders. Companies can sell bonds — which are a form of security that guarantees the repayment of the principal plus interest — to investors in order to increase funds.
Pros and cons of debt
While no one wants to be trapped in a cycle of unaffordable debt, there are instances in which debt can be beneficial. Before opening a new credit line, be sure to weigh the advantages and disadvantages to determine whether additional debt is a good decision for you.
|Taking on debt can provide access to investment opportunities that may lead to wealth building||Too much debt can be overwhelming and may limit future borrowing opportunities|
|Managing debt responsibly can help build your credit score and display your creditworthiness||If you don’t repay your debt, you’re likely to face legal and credit impacts|
|Can teach you how to manage and budget your money||Too much debt could lead to insolvency, or the inability to repay your debts|
Good debt vs. bad debt: What’s the difference?
Debt isn’t definitively good or bad, but there are certain qualities that differentiate debt that helps you reach your financial goals from debt that holds you back from those goals.
- Bad debt: Debt that can hold you back may look like high-interest debt, such as revolving credit card balances, which leave you paying far more for purchases than the item is worth. Payday loans with triple-digit APRs and short repayment periods can trap you in a cycle of debt, meaning you have to keep taking out new loans to repay the current one.
- Good debt: Debt can also help you become a homeowner, attain higher education and take control of your finances. For instance, mortgage debt could allow you to invest in a house that will appreciate in value and build equity. Student loans help you achieve an education that can increase your earning potential.
How to get out of debt
Whether you have a small or large amount of debt, you can work toward becoming debt free with time, patience and diligent effort.
Use a debt payoff method
The debt avalanche and snowball methods are two strategies for aggressively paying off debt. The debt avalanche method focuses on repaying debts with the highest interest rates first so you can save money in the long run. The debt snowball method, on the other hand, prioritizes paying off debts with the smallest balances.
Create a budget
Not only can budgeting keep you from taking on too much debt in the first place, but it can also help you quickly pay off debt. One common budgeting strategy is the 50/30/20 budget, which involves splitting your income between needs (50%), wants (30%) and debt repayment (20%).
Find a credit counselor
A credit counselor may be able to help you better manage your debt. If you’re a good candidate, credit counselors may also enroll you in a debt management plan in which they negotiate with your creditors to potentially lower your interest rates, dismiss fees or decrease your monthly payment amounts.
Consolidate or transfer debt
If you have high interest rates, rolling your loans into a single debt consolidation loan with a low APR may help you save money. You can also transfer your debt to a 0% intro APR credit card where you won’t have to pay interest for a period of time.
Frequently asked questions
While all loans are considered debt, not all debt comes in the form of a loan. Loans commonly provide a lump sum of money at a fixed interest rate. Debt, on the other hand, occurs when one party owes another party money.
A debt consolidation loan is a type of unsecured personal loan. Borrowers can roll multiple debts into a single loan, ideally with a lower interest rate. Debt consolidation can help borrowers better manage their debts and, hopefully, save money in the long run.
Collateralization occurs when a borrower uses a valuable asset to secure a debt — sometimes referred to as a secured loan. For instance, if you want to take out a personal loan but have bad credit, you may offer up a savings account as collateral in order to get approved for the loan. The downside is that if you’re unable to repay your debt, your creditor can legally seize your collateral.