Types of debt and how to use them
Key takeaways:
Debt is money that you borrow and have to repay, usually with interest.
Understanding the different types of debt could help you make better choices when you borrow.
Debt isn't a bad thing to have—as long as you manage it responsibly.
Taking charge of your financial well-being starts with understanding the basics of debt. Once you understand how debt works, you’ll be better prepared to make decisions that lead to a more comfortable and secure financial life.
What is debt?
Debt is money that you borrow and have an obligation to repay. Generally, you also pay interest for the privilege of borrowing.
Debt supports our modern lifestyle and drives the country’s economy. Imagine if you had to save tens of thousands of dollars before you could buy a car. Or hundreds of thousands to own a home. Being able to borrow helps us cover many types of emergencies, from healthcare to home repairs. Debt can help us get an education, start a business, or keep food on the table after a job loss.
Here’s what you need to know about the different types of debt so you can choose the right ones for your needs and manage them well.
Main categories of debt
There are two main ways to categorize debt:
Revolving vs. installment
Each has its pros and cons, and is right for different purposes.
Secured debt: loans backed by collateral
Secured loans require you to pledge something valuable that the lender can take if you fail to repay your debt. That something is called collateral. Often, the collateral is the thing that you’re borrowing to buy—a home is the collateral for a mortgage, and a car is the collateral for a car loan, etc.
Some personal loans are secured. Acceptable collateral for personal loans includes real estate, vehicles, art, jewelry, and investment accounts.
Secured credit cards are entirely or partially secured by money that you deposit with the card issuer.
Secured debt is less risky for lenders. So you may find it easier to get approval. Also, the interest rate on a secured debt may be lower than comparable loans that aren’t secured. (That’s not always the case, though.)
Disadvantages include extra processing time (when an appraisal is involved) and higher stakes for the borrower.
Unsecured debt: loans not backed by collateral
Unsecured loans don't require collateral. Sometimes, these are called signature loans. Most personal loans are unsecured. Most credit cards and personal lines of credit are also unsecured loans.
Because lenders have no collateral to fall back on, your credit history is much more important when applying for unsecured financing. In general, interest rates tend to be higher on unsecured loans compared with similar secured loans.
The main advantage of unsecured loans is that you don’t have to own something valuable that you can borrow against. Your credit standing is the main qualification factor. The disadvantages are higher interest rates than secured loans, and qualifying can be harder.
Revolving debt: Credit that can be used repeatedly
How does revolving debt work? You can borrow whenever you want, up to a pre-set credit limit. Credit cards, personal lines of credit, and home equity lines of credit (HELOCs) are examples of revolving credit.
Revolving accounts usually (but not always) come with variable interest rates. A variable interest rate can change as economic conditions fluctuate. Your payment depends on the current interest rate and account balance.
Revolving credit is convenient and flexible. It’s easy to make purchases with a tap, swipe, or click. And you only have to make a minimum payment each month. This can be helpful when cash is tight. However, convenience can make spending too easy. And low minimums can trap you into many years of payments and interest charges.
Installment debt: loans repaid with regular payments
Installment loans are simple. The lender dispenses the entire loan at once time, and you can’t borrow more without applying for a new loan. You repay it in equal installments (payments), usually monthly, until the balance is zero.
Auto loans, personal loans, home loans, home equity loans, and boat loans are installment loans.
Installment loans have a couple of advantages. First, most installment loans have fixed interest rates. A fixed rate means your payments will be predictable and won’t change. And installment loans have definite terms (the life of the loan). You know exactly when your balance will be zero. As part of a debt repayment strategy, some people consolidate revolving debt with an installment loan.
Types of consumer debt
Many types of loans are tailored toward specific uses: mortgages for homes, auto loans for cars, student loans for education, credit cards for smaller retail purchases, and so on. Choosing the right loan for the right reason helps you manage debt more easily.
Credit card debt
Type: revolving debt, usually unsecured
Credit cards’ main advantage is convenience. You can use one virtually any time you like. Many people take advantage of purchase protection, rewards, and other perks offered by their card.
However, credit cards generally carry higher interest rates than other mainstream forms of credit. Low minimum payments can trap the unwary into decades of debt. And credit cards are less secure than other forms of borrowing: 65% of credit card users have been victims of credit card fraud.
Student loan debt
Type: installment debt, unsecured
Student loans are taken out for one purpose: to finance higher education. Government student loans tend to have better interest rates and more consumer protections. However, there are limits to government-backed loan amounts, so students may turn to private financing to fill in the gaps.
Student loans can make higher education available to more people. Students may defer repayment until they graduate and choose income-driven plans to keep payments manageable. However, graduating with high student loan balances can keep borrowers in debt for decades, making it difficult to buy a home or start a family.
Mortgage debt
Type: installment debt, secured
Mortgage debt is secured by real estate. All of these loans are mortgages:
Loans to buy a home or lot
Construction loans
Mortgage refinance loans
Reverse mortgages
The thing to know about mortgages is that they stand on three legs: your credit score, your down payment, and your debt-to-income ratio. The stronger your showing on these three factors, the easier it’ll be to get approved and minimize your costs.
Mortgages have a whole set of laws and consumer protections that are unique to them.
Auto loan debt
Type: installment debt, secured
Most auto loans come from the car dealer or a bank or credit union.
Auto financing from dealers can be more expensive because the dealer adds in a profit margin or takes a commission on the financing. However, dealers also have access to promotional financing on models that the automaker wants to move.
Auto loans from banks and credit unions often have better terms than dealer financing.
There are other ways to borrow to buy a car if you don’t want a traditional car loan.
Personal loan debt
Type: installment debt, usually unsecured
Personal loans are installment loans, usually with fixed interest rates and payments. That can make budgeting easier. You can use a personal loan for almost anything (subject to the lender’s policy). They can be helpful for credit card debt consolidation because interest rates tend to be lower than credit cards and because you’ll know your payoff date.
Medical debt
Type: usually installment debt, unsecured
Those who need or want medical care but can’t pay in cash must borrow. Medical offices, banks, and other lenders offer medical loans or lines of credit. These are usually unsecured personal loans or credit lines, but some people put medical expenses on credit cards.
Hospitals with emergency rooms are required to provide essential care and request payment later. If you can’t pay your bill in full, hospitals generally offer payment plans at low or no interest. For this reason, it’s generally better to ask for a hospital payment plan rather than taking out a loan or using a credit card for necessary medical services.
Payday, check advance, and auto title loans
Type: secured or unsecured, installment
Short-term loans can bridge the gap between paydays when emergencies strike. Unfortunately, these loans are crazy expensive. The average annual interest rate is nearly 400%.
Most people take out these loans for two to four weeks, so the fees ($10 to $30 for every $100 borrowed) don’t seem that high. But when it’s time to repay, 80% of borrowers find they can’t, and end up rolling the loan over and paying a new fee—eight times on average. If you borrow $500, pay $75 in fees, and roll your loan over eight times, you’ll have to repay $1,175.
Auto title loans require you to put up your car as collateral. You can lose your car if you don’t repay your loan. Auto title loan fees often translate to an interest rate of about 300% per year, and borrowers roll these loans, again, an average of eight times.
Almost any loan is better than these short-term options.
Retail store cards
Type: unsecured, installment
Retail store cards are credit cards offered by retailers to encourage spending at their stores. They may offer a large discount when you sign up. You might also be tempted with perks like merchandise, free shipping, or access to “members only” sales.
Retail cards can be easier to get, so they could be useful when you’re trying to establish credit. The downside of retail cards is that they carry higher interest rates and may encourage you to spend more than you otherwise would.
What's next: taking control of your debt
If your debt is dragging down your finances, you may need to restructure it. For instance, debt consolidation with a fixed-rate installment loan might help you get rid of it faster or make it more affordable. Other solutions include debt resolution, credit counseling, and bankruptcy.
Frequently asked questions
Can paying off debt improve my credit score?
Paying off debt, especially credit card debt, could improve your credit standing.
Credit scores take into account how much credit card debt you have in relation to your credit limits. This is called credit utilization and it’s a big factor in how your credit score works. The only thing that affects your credit score more is your payment history.
What should I do if I'm struggling to pay my debt?
If you’re struggling with debt, you have a few options.
If you haven’t fallen behind, you might be able to get a debt consolidation loan with a lower monthly payment.
If your problems are serious and you can’t afford your debts, other solutions include:
Is it better to pay off debt or save money?
Most debt incurs interest charges that exceed what you can earn on savings, so you’ll want to prioritize debt repayment before turbo-charging your savings. Consider establishing a small emergency fund first. Then push hard to clear your high-interest debt.
