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In the second quarter of 2020, consumer debt in the United States hit a record of $14.3 trillion according to the Federal Reserve Bank of New York. While this is a staggering number, the fact remains that most people have to deal with some form of debt at some stage of their lives. For many people, this could involve taking out a mortgage, car loan, or even student loans to pay for their education. Given that many people use debt, I want to talk about the types of debt and also share my thoughts on the long-standing debate of good debt vs. bad debt.
What is Debt?
Before I jump into the details about the types of debt, I want to talk a bit about what debt is.
Debt comes in all sorts of different forms. At its simplest level, debt is when someone (usually a financial institution) provides the use of their money for some amount of time. In exchange for use their money, the borrower will pay the bank interest as a “thank you” for using their money.
Common types of debt include:
- Mortgage Loans (including home equity loans)
- Student Loans
- Car Loans
- Credit Cards
- Just about anything else you can imagine needing money for
Now that you know more about what debt is in general let’s dive into some specifics about the types of debt.
Secured Debt
The first type of debt I want to talk about is secured debt. Secured debt is when a borrower pledges some form of collateral in exchange for a loan.
Take a mortgage, for example. If you take out a mortgage, you are pledging your house as collateral to the bank. In other words, if you don’t make your mortgage payment, the bank has the right to take your home.
If you’ve never thought about it this way, whereby you are giving the bank the right to take your asset if you don’t make your payments, it can sound scary. But in reality, if you understand how this type of loan works, it’s not that scary after all.
The key with secured debt is only to take on debt that you are 99.9% sure you will be able to pay back. Where people get into trouble is when they start taking on more debt than they can handle, and then, ultimately, their assets get repossessed.
Why does secured debt have a low interest rate?
It’s worth noting that secured debt often has an advantage for the consumer. Yes, you heard that right, you do get something in exchange for pledging your asset as collateral.
Secured debt usually carries a lower interest rate. Ever wondered why mortgage interest rates are so much lower than credit card interest rates? This is why.
Because the bank has the right to take your asset if you don’t make your payments, they consider this type of lending to be lower risk, and thus they can offer a lower interest rate.
For example, if your house is worth $100,000, and you have a loan for $70,000, the loan is secured by $100,000 of collateral. So, if you don’t make payments on your $70,000 mortgage, the bank can take your house, sell it for $100,000, and they’re no worse for wear.
That’s why mortgages, home equity loans, and car loans, etc. usually have such low-interest rates – reasonably predictable collateral values back the loan.
Unsecured Debt
The second type of debt is unsecured debt. This type of debt isn’t backed by any sort of collateral. In other words, if you don’t make your payments, the bank has a problem, because they have little recourse to collect the money they lent you.
Common examples of these types of loans are credit cards and student loans. You may be wondering how student loans have relatively low-interest rates, while credit cards have high-interest rates even though they are both unsecured loans.
There are a few reasons for this, but one reason is that it is difficult to wipe out student loan debt, even in a bankruptcy process. Credit card debt, on the other hand, is easier to wipe out in bankruptcy. Additionally, credit cards are revolving debt, and student loans are considered non-revolving debt – more on that in a minute.
The critical thing to remember with unsecured debt is that you are not pledging an asset when you take out a loan. The bank can come after you to repay the debt, but they can’t take an asset like a house, car, etc.
Revolving Debt
The next type of debt is revolving debt. Revolving debt is a type of debt without a fixed repayment period. Take credit cards, for example. As long as you pay at least the minimum payment due each month, there is no fixed date by which you have to repay the loan.
Revolving debt is generally expensive (high-interest rate) because the lender does not know when the loan is going to be repaid.
For example, let’s say you charge $1,000 on a credit card with an 18% interest rate, and your minimum payment is $25. With interest, it would take over five years to pay back the bank if you paid just the minimum payment.
Because the bank doesn’t know when they’ll receive their money back, they charge a premium for this type of loan.
Non-Revolving Debt (Installment Loans)
The opposite of revolving debt is non-revolving debt (also called an installment loan). These types of loans have a fixed payment period, and payments are typically monthly.
Mortgages are a common example of an installment loan because you pay a fixed amount each month, and the bank knows when they can expect their investment back.
Because these loans have a fixed repayment period, they generally have lower interest rates.
Most types of debt fall into either the unsecured or secured bucket and the revolving or non-revolving bucket. For example, a credit card falls into two different categories of debt: it is both unsecured and revolving. A mortgage, on the other hand, is both secured and non-revolving.
Other Types of Debt
There are a couple of other types of debt that I want to highlight briefly.
Fixed Interest Rate vs. Variable Interest Rate Debt
First, some debt has a fixed rate of interest, while other debt has a variable rate of interest. For example, many people choose a 30-year fixed-rate mortgage. All this means is that the interest rate will never change for the life of the loan.
Alternatively, you may have heard about adjustable-rate mortgages. With this type of mortgage, the interest rate can change over time, meaning that if interest rates go up, so will your payments.
Credit cards are an example of variable interest rate debt. The bank can change the rate of interest, thus altering the amount you’ll owe the bank in interest costs.
In general, you’ll want to steer clear of variable interest rate loans where possible, as they can add an element of unpredictability to your financial life.
Deductible vs. Non-Deductible Debt
One other type of debt to note is deductible vs. non-deductible debt.
Certain types of debt allow you to reduce your taxable income when it comes time to pay Uncle Sam. This type of debt is known as deductible debt. In other words, you receive tax benefits for the interest you pay.
The most common type of deductible loan is a mortgage loan, whereby you can typically deduct mortgage interest from your taxable income.
Most types of loans are non-deductible, however, meaning you get no tax benefit for the mortgage interest you pay.
Good Debt vs. Bad Debt
If you know anything about Dave Ramsey and his 7 baby steps to financial management, you know that he is the most fervent amongst all personal finance gurus in advocating the elimination of all debt.
Well, spoiler alert, I am not Dave Ramsey. Instead of telling you that debt is the enemy, I’d rather tell you how to use debt thoughtfully as part of your overall financial picture. Because when used correctly, debt can help you build wealth with limited risk.
The way I usually think about good debt is that it is a form of debt that allows you to buy appreciating assets at low-interest rates.
Bad debt, on the other hand, is usually used to buy items that lose value over time, or at high-interest rates.
Good Debt: Mortgages and Student Loans (Maybe)
As an example of good debt, I generally consider mortgage debt to be a good debt. Why? Because it allows you to buy a property that will typically increase in value over time, and the interest rate is very low.
I define a low-interest rate as an interest rate that is less than you could earn by investing (historically ~7% over the long run in the stock market).
Of course caveats to saying that mortgage debt is good debt, like the fact that you shouldn’t buy more house than you can afford. But I am saying that debt can be useful when used responsibly to acquire assets.
Student loans are a tricky one. If you’re using student loans as a mechanism to earn a college degree, which will create a significant return on investment, then I believe student loans can be a form of good debt. If, however, you are taking on student loans for a degree that will not give you a significant salary boost (such as liberal arts), student loans are bad debt.
Bad Debt
Other examples of bad debt include credit card debt, car loans, etc. I think it’s pretty evident that credit card debt is bad (because the interest rate is usually high). Car loans generally aren’t great either (because you are buying a depreciating asset). However, car loans are a bit tricky because I realize that most people can’t pay out of pocket for a “new” car.
For this particular kind of debt, I suggest you buy a used car that you can afford. If you manage your other debt responsibly (i.e., no credit card debt, moderate mortgage debt, etc.), I think leveraging a car loan can be acceptable in certain circumstances. However, if you can avoid it, that’s even better.
When it comes to debt, the key is managing your debt responsibly. Take out a mortgage for a home you can afford, try to avoid car loans if you can, and only take out student loans if they will produce a return on investment that more than covers the long-term financial burden of student loans. Avoid all other types of debt, if at all possible.
If you find that you are already in a substantial amount of debt, check out our After School Finance guide on How to Get Out of Debt.
Types of Debt: A Summary
While there are countless different flavors of debt, I have covered the main types of debt, including:
- Secured vs. Unsecured Debt
- Revolving vs. Non-Revolving Debt
- Fixed Interest Rate vs. Variable Interest Rate Debt
- Deductible vs. Non-Deductible Debt
Usually, debt will fall into multiple categories, so understanding the characteristics of each type can be helpful.
I’ve also talked a bit about why I am a believer that some forms of debt can be valuable if used strategically to build wealth.
Debt is a complex topic, but hopefully, you now have a better understanding of the different types of debt so that you can use it thoughtfully as part of your overall financial picture.
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