4 types of debt and how they can impact your finances

Personal finance can be complicated, especially when you start learning how debt works. A great way to demystify the topic is to first understand the basics, such as the different types of debt. 

Below, we offer a broad overview of debt in general and cover the four main types of debt, how they work, and how they can impact you financially. This can help you on your way to building a strong foundation in financial literacy.

What is debt?

Before we hop into what types of debt there are, you need to know exactly what debt is. Debt is when you owe someone else money. Say you borrow five bucks from your friend to grab a slice of pizza at the mall because you forgot your debit card at home. You are now in debt to your friend $5.

Sure, your friend isn’t going to draw up terms and conditions of this short-term loan and charge you hourly compounding interest until you pay him back tomorrow, but this is still a debt.

Let’s review some of the main components of debt:

• Original balance: This is the original amount of money you borrowed. In our example above, this is the $5 you borrowed from your friend.

• Principal balance: This is the amount of money you still owe. So, if you found $2.50 in your pocket and immediately gave that to your friend, your new principal balance would be $2.50.

• Interest rate: This is the percentage of the principal balance the lender charges you for loaning you cash. This is typically where most lenders make their profit. So, if your friend charged you 10% daily interest, and you paid them the next day, you would incur a $0.50 interest charge and now owe them $5.50. Interest is typically expressed as an annual percentage rate (APR).

• Loan term: This is the amount of time you have to pay off the loan. So if your friend said you had 10 days to pay them back, the loan term is 10 days. Remember that if you have the 10% daily interest rate, you will also pay 10 days of interest, which leads us to...

• Compound interest: This is when you are charged interest on top of interest. For example, if you took the full 10 days to pay your friend back in full, you would pay interest on top of the previous days' interest. So, on day one of the loan term, your principal balance would rise to $5.50, then to $6.05 ($5.50 + 10% interest = $6.05) on day two, then $6.65 on day three ($6.05 + 10% interest = $6.65), and so on until you pay off the balance in full. Not all loans have compound interest, though. Some use simple interest where the interest charges are based solely on the principal balance. 

What are the various types of debts?

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With a good understanding of the basics of debt, it’s time to dive into the actual types of debts. Four different types of debts exist: secured debt, unsecured debt, installment debt, and revolving debt. Let’s dig in.

Secured debt

A secured debt is a loan with collateral. Collateral is a valuable item (or asset) — like a car, house, or business — that the lender can take if you don’t pay your debt. Typically, the collateral is the item you bought with the loan, such as the vehicle you purchased with an auto loan or the home you bought with a home loan.

Here are some examples of secured debt:

• Car loan: Most people don’t have enough cash on hand for the full price of a car, so they get a car loan and pay for the car in smaller payments over time. The car is the collateral. 

• Mortgage loan: A mortgage is used to borrow the money you need to buy a home. The home is the collateral

• Home equity loan or home equity line of credit (HELOC): If you’re a homeowner with expenses that you need to borrow money for, you can use the equity in your home to take out a loan or line of credit. We’ll talk more about equity later, but for these types of secured debt, your home is the collateral.

• Business loan: A business loan can be used to open a business, buy new equipment, or purchase real estate for an office building — among other things. Because these loans can sometimes be quite large, they are often secured by the business itself or an asset it owns. Many times, businesses will use the business’s building and property as collateral or the equipment it purchased with the loan. 

• Title loan: This is a short-term loan that people sometimes get to make ends meet during a rough patch. Title loans often have super-high interest rates and costly repayment terms. A car is used as collateral for the loan.

Unsecured debt

Unsecured debt doesn’t have collateral, making it a riskier venture for the lender. Because of this, unsecured debt often has higher interest rates than secured debt.

Here are some examples of unsecured types of debt:

• Credit card: With a credit card, you have a spending limit known as a credit limit. If you have a credit limit of $500, that means you can use the card to make purchases until you’ve spent $500. After you pay the money back, you can keep using the card for more purchases.

• Student loan: On average, college tuition costs between $10,423 and $39,723 each year. Student loans can be used to pay for the tuition as well as buy books, buy cafeteria food, and pay for other living expenses in college. Both federal and private student loans are available. Federal loans usually have lower interest rates than private loans.

• Personal loan: A personal loan is a line of credit to use for various things, such as money to fix your car, cash to make a small repair on your home, or funds to cover an emergency.

• Debt consolidation loan: This is a loan you use to help you pay off other types of debt, including credit cards, medical bills, student loans, personal loans, and even secured loans.

Installment debt

The third type of debt is installment debt, which can be either a secured or unsecured debt. These loans typically have fixed monthly payments and repayment terms. For example, with a car loan, you might owe $250 each month for 60 months. Once you pay off the balance, the lender marks it as paid in full and closes the account.

Some examples of installment loans include:

• Auto loans

• Mortgage loans

• Home equity loans

• Personal loans

• Debt consolidation loans

Because installment debt has fixed monthly payments and a fixed term, it’s relatively easy to plan for the expense in your budget.

Revolving debt

Revolving debt has a set spending limit, and you can borrow money from it multiple times as long as you haven’t exceeded the spending limit. If you do reach the limit, you can pay back the money you owe to free up the spending limit and use it again. 

Some common examples of revolving debt include:

• Home equity lines of credit (HELOCs)

• Credit cards

• Personal lines of credit

• Secured credit cards

How can debt affect your financial health?

Debt can create issues when not managed properly, but it can also positively impact your financial health when used properly. Let’s take a look at two pros and two cons.

Pro: Strengthen your credit history

When you have a loan, the lender will report certain information about your account to the credit bureaus. The bureaus take the information they receive and add it to your credit report. Your credit report will then influence your credit score.

Your payment history is an important part of your credit score. So the more on-time payments you make, the better. 

When you apply for other loans or credit cards, the lender will look at your credit report and credit score to decide if they should approve your application. With a good credit history, a lender may offer you better payment terms and interest rates.

Pro: Build equity

When you use debt to buy an asset, like a car or a home, you can build equity. Essentially, equity is how much of the asset you own. You can figure out how much equity you have by subtracting how much you owe on your loan from how much the asset is worth. 

For example, if you have a home that’s worth $200,000 and you still owe $50,000 on your mortgage, you have $150,000 in equity. Let’s say in five years the value of your home increases to $300,000 and you’ve paid off your mortgage. You would then have $300,000 in equity.

You can use equity to build wealth or you can use it as collateral for a home equity loan or a HELOC.

Con: Accumulate more debt

This is how debt has earned its bad reputation. Credit cards are the best example of how debt can create more debt, unless the card is paid off in full each month by the due date.

When you receive your monthly credit card statement, you’ll see the minimum payment due and a due date. For example, you might owe $35 by the 15th of the month. If you make the $35 payment by the due date, you’ll have made an on-time payment, and you won’t be charged a late fee.

However, there’s another number on your credit card statement to look at: your balance. This is the total amount you owe on the credit card. Depending on how much you spend and if you don’t pay off the full balance each month, your balance will often be higher than the minimum payment due. For example, you may have a $35 minimum payment and a balance of $300.

If you only pay the $35, you’ll still have a credit card balance of $265. After the due date, you will incur interest charges on the $265 balance. The interest will compound monthly or even daily until you pay the balance in full. 

It’s the compound interest that can make it difficult for people to pay off credit card debit.

Con: Lose collateral

If you have secured debt and aren’t able to make the payments, you might lose your collateral.

For example, if you fall behind on your mortgage payments, the lender might foreclose and take your home. Similarly, if you don’t keep up with auto loan payments, your lender can repossess your car.

Learn more about personal finances with the Greenlight app

Understanding the different types of debt is a critical step in financial literacy, as understanding what it is and how it works is necessary before using it. 

You can further your family’s financial literacy with the Greenlight app. With the app’s educational content and the Level Up game, your child will be a financial whiz in no time. 

Your child will also get an easy-to-use debit card, the ability to learn how to invest, and much more. Sign up for Greenlight today!