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For better or for worse, debt is a common part of life. Borrowing can make it possible to buy a home or car, attend school and finance other large purchases. And while debt can be useful for achieving all types of financial goals, it can also become a large burden if you take on debt for the wrong reasons or without fully understanding what you're agreeing to.
Not all types of debt are created equal, however, and different types of debt are useful for different ends. To ensure what you borrow works for you, not against you, here's a breakdown of the main types of debt and what you need to know about each.
What Is Debt?
Debt is money you borrow and then repay to another party, often called the lender or creditor. When you take on debt, you usually agree to a contract specifying when you'll repay the debt, plus how much interest and other fees you'll be charged in exchange for borrowing.
Debt can be a useful way to achieve goals such as buying a home, going to college or financing a car, and different types of debt are best suited toward specific purposes and goals. Sometimes, this distinction is fairly obvious; while you can use a credit card to buy groceries or shop for clothes, you can't use one to buy a house. And in the same vein, you can't generally use a car loan to pay for goods and services.
But sometimes, the different types of debt and their best uses are a bit less obvious. Understanding the various categories of debt is important for being an informed borrower.
Secured Debt vs. Unsecured Debt
What Is Secured Debt?
A secured debt is a loan that's backed by some form of valuable property, known as collateral. In other words, taking on a secured debt requires you to put a piece of property on the line, typically a house or a car. If you stop making payments, the lender can seize the property you've offered as collateral.
Examples of secured debt are home mortgages and auto loans. These debts are tied to the value of the car or home you purchase with the loan. If you stop making payments, the lender can repossess the property tied to the loan. In the case of a mortgage, this is called foreclosure.
What Is Unsecured Debt?
An unsecured debt is a loan that isn't tied to any collateral. Credit cards and medical bills are common examples of unsecured debt. Oftentimes, personal loans are also unsecured debts, though some personal loans do require collateral.
Secured vs. Unsecured Debt
Whether to take out a secured or unsecured loan isn't always a matter of choice. In the case of auto loans and mortgages, the property you're financing with the loan is itself the collateral, so mortgages and auto loans are always secured. In other cases, whether to get a secured or unsecured loan often comes down to what you can qualify for based on your creditworthiness, income and other factors.
Unsecured debts are riskier for lenders because they have less ability to recoup their investment should you stop paying. For that reason, unsecured debts often have stricter credit and income requirements. If your credit is low, you may only have the option to get a secured loan. Making on-time payments can help you broaden your future borrowing options.
When you have the option, you might choose to take out an unsecured loan so you don't have to put your home or car on the line. On the other hand, secured debts often offer lower interest rates than unsecured debts. If you're confident you'll be able to afford payments, you may find this to be the more attractive option.
Revolving Debt vs. Installment Debt
When it comes to how you borrow and repay debt, there are two main types of credit and repayment structures: revolving debt and installment debt.
What Is Revolving Debt?
Revolving debt is a type of debt, such as a credit card or home equity line of credit (HELOC), that allows you to repeatedly borrow and repay money up to a set credit limit. You can charge purchases up to the limit, then repay your balance—usually with interest—with some flexibility. Typically, revolving debts have a set minimum monthly payment, and you'll accrue interest on only the balance you carry. Revolving debts typically have variable interest rates.
What Is Installment Debt?
An installment loan is a loan you receive in a lump sum and then repay with set terms, typically in equal installments with a fixed interest rate. Common examples of installment debt are personal loans, student loans, mortgages and auto loans.
Revolving vs. Installment Debt
For any type of revolving debt, the major benefit is that you can access and repay your debt flexibly, and you'll only pay interest on what you owe. And as you repay your balance, you can continue to use the credit you free up.
As long as you pay at least the minimum due each month, you'll be able to keep your debt in good standing and pay it off on your own timeline. For example, you can use your credit card for everyday spending on bills and groceries and pay off your purchases with your next paycheck. It's usually best to pay off revolving debts as soon as possible, though, as interest can accrue quickly.
Installment debts can also be an attractive option in some cases because they typically offer fixed interest and a predictable monthly payment. They can also offer lower interest rates than some revolving debts. For example, when you use a debt consolidation loan to pay off a credit card debt, you're converting a revolving debt into an installment debt—ideally with lower interest.
Types of Consumer Debt
Beyond broad categorizations of debt, there are specific types of consumer debt. Different credit products are intended for different purposes. Here are the most common types of consumer debt:
How to Pay Off Debt
If you're shouldering a large balance, getting out of debt can be a challenge. Here are some steps you can follow to pay off your debt.
1. Take inventory of your debt. Make a list of everything you owe, noting your balance, interest rate and minimum monthly payment. Sometimes, facing your debt can be stressful. But getting clear on exactly what you owe makes paying off debt easier to visualize.
2. Budget for repayment. Create a plan for how you'll budget your money toward expenses, debt and saving. Consider the 50/30/20 budget or another budgeting plan. If money's tight, learn about ways to cut back spending and consider looking for ways to increase your income, such as with a new side hustle or part-time job.
3. Consider a repayment strategy. There are a lot of different approaches to paying off debt: the debt avalanche method, debt snowball method and the lesser-known debt snowflake method. If you have high credit scores, you can also consider a debt consolidation loan or a balance transfer credit card.
4. Consider credit counseling. If you need help charting a course out of debt, consider seeking out a nonprofit credit counseling service. Credit counselors help you go over your debts to devise a plan for repayment, and they can also help you with budgeting and other personal finance basics.
The Bottom Line
Being an informed borrower can help you keep debt working in your favor, rather than becoming burdensome. Build up a working knowledge of the types of debt and how they work before you apply to borrow. That way, you can feel confident that you're applying for the right type of credit for your goals.
Another strong way to understand your personal debts and keep tabs on exactly what you owe is to sign up for free credit monitoring with Experian. You can check your credit report to see all your revolving and installment loan debts, including credit card debt, mortgages, student loans and auto loans. You'll also receive alerts to changes in your report and a free credit score.