In simplest terms, debt is a specified amount of money that is borrowed by one party from another. Debt can be borrowed from an individual, corporation, bank, or other institution.
It is used by many, including businesses, to make purchases that they would not typically be able to afford out of pocket. But debt comes with a financial agreement. The borrowing party must agree to pay back the money at a later date, typically with interest.
How Does Debt Work?
Debt is what is owed by an individual or business when they are given a form of credit – usually in the form of money. The person who receives the credit is known as the borrower or debtor. On the flip side, the person who provides the credit to the borrower is the creditor or lender.
When you receive a credit, you as the debtor will enter into a legally binding contract agreement stipulating the terms which the debt will be repaid. Often called a loan, the terms of your contract include the amount of time you have to repay the creditor for the full amount of your loan, plus interest.
Types of Debt
There are various forms of debt. It comes in all shapes and sizes – from car loans to mortgages, credit cards to student loans. You may think that all debt is created equal, but this is simply not the case. They all come with a loan agreement including terms for payment plans. However, they all have their own implications not only on your tax liability, but on your credit score as well.
Your credit score plays a vital piece in determining your credit worthiness. Creditors will review your creditworthiness and your debt-to-income ratio to determine if you meet their loan requirements.
What Is Secured Debt?
The two most common types of debt are secured debt and unsecured debt. The main difference between the two is the presence or absence of collateral.
With secured debt, the borrower puts an asset as collateral for the loan. A secured debt contract means that if you default on your loan, the lender can use your asset to repay the funds that they have credited to you.
The most common types of secured debt are mortgages and auto loans. The home or vehicle you purchase is used as collateral to be financed. The risk of loss tends to be higher on the borrower’s obligation versus the creditors. That is why secured debt is typically easier to get and why interest rates are typically lower than unsecured debt.
What Is Unsecured Debt?
On the flip side, unsecured debt has no collateral for the lender. In the event that the you defaults on the debt, the creditor has no collateral and has to initiate a lawsuit to collect what is owed. These loans require a greater risk on the lenders part, which results in stricter loan requirements and higher interest rates.
The most common types of unsecured debt include credit cards, medical bills, and personal loans. However, there are other unsecured debt obligations. Contracts such as rent, utility bills, student loans, and gym memberships are all forms of unsecured debt.
If you default on your unsecured debt obligations, the creditor cannot take anything that is yours without obtaining a judgement against you through court.
What Is Revolving Debt?
Unlike typical loan agreements, revolving debt does not come with specific payment installments. As a borrower, you borrow against the credit line as you need it, then pay back the portion that is borrowed, along with the specified interest.
Credit cards are the best example of revolving debt. You can utilize your credit card as your needs change and are not required to pay off the balance in full every month. Instead, you can borrow against your credit line over and over, and as long as you pay your monthly minimum, you do not have to pay your balance immediately. However, it is important to note that you will continue to accumulate interest.
Are Mortgages a Form of Debt?
When you purchase a property, you enter into a mortgage agreement with a lender. This allows you to take ownership of the property, but if you do not repay the money your home will be foreclosed and used as collateral.
Mortgages are commonplaces where people overextend their debt. Typically, a lender will tell you how much you are qualified to borrow, but how much you can repay can vary greatly. When you begin a home search, look within a price range that does not stretch your budget too thin, even if you are approved for more. Consider not only your income, budget, and savings, but also expenses such as insurance, property tax, and private mortgage insurance. Don’t forget to account for emergencies!
When you enter a mortgage knowing how much you can comfortably pay each month, you will be less likely to default on your loan.
How To Get Out of Debt
Being in debt can negatively impact your life. For example, if you want to purchase a house, but you have too high of a debt-to-income ratio, you will not be approved.
To get out of debt to create a more financially stable financial future, you must:
Organize your debt and bills: Compile everything! Go through credit card statements and bank statements. Write down all the recurring bills, loans, and other expenses that you owe.
Make the most of your budget: Building a budget is key to financially planning and paying off debt.
Work freelance or side hustles: Need an extra income boost? If you have special skills, from construction to web design and everything in between, consider earning extra cash from a side job. You can also look at driving for services like Uber or renting a room in your home on Airbnb. Don’t over exhaust yourself with your side hustle. Instead, make a plan for a short-term stint to help you earn extra to pay off your debt, then focus on your budget to stay out of debt in the future.
Tips To Reduce Debt
While getting into debt can be quick and easy, the ramifications of taking on debt can last years, even decades. The first step to reduce debt is quite simple – stop creating more debt. You won’t be able to reduce debt if you continue to add more. After you have organized your budget, pick a debt and give it all you’ve got. Keep chipping away at the debt until it is paid off. Then pick another debt and continue to do the same until you see your debt drastically reduced.
For longer term debts like mortgages and auto loans, consider working with your creditor to lower your interest rate. Refinancing your loan can lower your payment. If you continue to make the same payment, the difference will be applied towards your actual balance, not interest!
What Is Debt Consolidation?
Another way to reduce your debt is to consider debt consolidation. All your debt will be consolidated into one loan, the funds will pay off all your other accounts. You will then only have one loan to focus on paying off monthly instead of multiple accounts.
Good Debt vs Bad Debt
Have you heard of good versus bad debt? While debt can typically have a negative connotation, there truly is debt that is considered good. Good debt helps increase wealth over time or build wealth. Debt like mortgages, business loans, and student loans are all considered good debt.
Bad debt is debt that does little to improve your financial future. Things like credit cards, personal loans, and vehicles do not improve your financial outcome and are generally considered “bad.”
Final Thoughts: Alternatives To Debt
Before you add more debt, determine if it is truly worth borrowing. Ask yourself this vital question: “Will this debt pay me back more than I put in?” Did you answer no? If so, consider planning to save money to reach your desired goal instead of taking on additional debt.
There’s no time like the present to start tackling your debt. Come up with a plan, whether it be budgeting, refinancing, or debt consolidation, to help you focus on your long-term goals. Healthy money habits like budgeting, savings, and refraining from adding unneeded debt will help your overall financial outlook. If you need professional help tackling your debt, consider speaking to a financial advisor to help guide you.