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If you wish to eliminate your debt, you will want to understand the most common types of debt you have. Many kinds of debt can affect your finances, and some might have better terms and conditions than others.
This article will help you understand how each type of debt works and what it means for your finances going forward so that you can make the best decision for yourself or your family.
1. Secured debt
Secured debt is backed by collateral.
Should a borrower fail to repay a debt, the bank may take possession of the collateral, sell it, and use the revenues to settle the debt. Unsecured debt is regarded as a riskier investment than secured debt since it’s not guaranteed by the asset you bought.
Mortgages, where you make a down payment and then borrow additional funds to purchase a home, are the most common type of secured debt. The bank has the right to seize ownership of your home if you don't make your payments on time.
Another type of secured debt involves taking out an auto loan from a bank or finance company to purchase a car. You'll need to pay back this loan with interest over time, but if you don't keep up with payments, the lender can repossess the vehicle from you!
Secured debt products typically have lower interest rates. You may also be eligible for a higher loan limit and a more extended repayment period.
People with negative credit or no credit history may find secured debt to be a preferable alternative. It's also a fantastic tool if you need to rebuild your credit.
Utilizing a secured loan responsibly might raise your credit score, enabling you to later be approved for better-unsecured loans. Additionally, some secured credit cards provide additional benefits, such as free identity theft and credit monitoring.
2. Unsecured debt
This is a debt that is not backed by collateral. This means the creditor does not have any security for the loan, such as a car or house, to secure it. Unsecured debt can lead to a variety of negative consequences for a lender, including:
- Defaulting on payments
- Requiring bankruptcy protection and filing for Chapter 7 liquidation (bankruptcy)
- Being sued by creditors
Unsecured debt tends to accumulate penalty fees and interest. These debts can accrue expensive late fees and other penalties to incentivize people to make payments on time.
For example, if your credit card is due in two days, but you pay it late, the bank will charge a $25 late fee that's added to your loan balance. If you don't pay on time again within 30 days, they'll also tack on another $25 fee, and so forth.
3. Revolving Debt
Revolving debt is credit that you can draw on indefinitely if your accounts are open and you have yet to reach your limit. Credit cards and lines of credit are typical examples of revolving debt.
It allows you to borrow a certain amount while only requiring you to repay a certain percentage each month, plus interest (though interest payments can be avoided by paying in full).
Because you are not required to pay off the balance in full at any time, you can continue borrowing and re-borrowing from your card as long as you stay within the total amount of credit granted.
Since revolving credit is so easy to obtain, it can be a convenient way to manage your spending. Using credit cards can also give you the benefit of earning rewards points.
However, you must exercise caution not to charge more than you can afford to repay. Otherwise, you risk accruing significant interest charges or falling into too much debt that is difficult to repay.
Furthermore, a high credit utilization ratio can lower your credit score. If you need money to pay for a big investment, like a house remodel, a personal loan might be a better choice than revolving credit.
4. Installment debt
An installment debt is the most common form of debt in the United States.
An installment debt is a loan repaid in regular installments by the borrower. In most cases, installment debt is repaid in equal monthly payments, including interest and a portion of the principal.
This is an amortized loan, which requires the lender to create a standard amortization schedule outlining payments over the life of the loan.
An installment debt is a popular consumer financing option for large-ticket items such as houses, cars, and appliances. Lenders also like installment debt because it offers regular issuer payments based on a set amortization.
The amount of the monthly installment debt payments will be determined by the amortization schedule. The total principle issued, the interest rate applied, any down payment, and the total number of installments all affect the amortization plan.
How to Pay Off Debt
If you need help to make ends meet every month, it can be hard to see any way out of your financial mess. However, there are some actions you may take to help you leave your current circumstance and enter a better one later on:
1. Cut expenses
First, look at your spending and see if there's any room for improvement. You might be shocked at how much money you can save by making a few minor adjustments.
As a general rule, it's best to start by cutting your expenses, then look at ways to increase income. That doesn't mean you should stop spending money on anything. Rather than buying new clothes every month or going out to eat twice a week, try shopping at thrift stores or making meals at home.
At first, cutting your expenses may not seem a good idea because you aren’t getting to indulge in all of your favorite things like you used to, but as you see yourself progressing financially, it’ll make perfect sense and motivate you to keep going.
2. Get on a zero-based budget
Zero-based budgeting (ZBB) is a budgeting tactic in which all costs must be justified for a new period or year beginning with zero instead of starting with the previous budget and adjusting it as needed. This means you can only spend what has been earned, and everything else must be saved or use to pay off debt.
Many people find this approach difficult because they only know where they're going with their finances once they get there. But it becomes easier to access as you get into the habit of assigning every penny at the start of the month and making small adjustments as the month continues.
How to make a zero-based budget
The first step in creating a zero-based budget is adding up all your income. This includes salary, interest, dividends, and rental income; capital gains or losses; social security payments; etc.
The next step is to categorize your expenses. To make sure you're getting the most out of your budget, it's important to categorize your expenses. Making use of a spreadsheet tool like Microsoft Excel or Google Sheets, create columns for fixed and variable costs. This will allow you to see how much money is left over at the end of each month and whether or not there are any gaps in your spending patterns.
The first things you budget for must be your food, shelter, transportation and utilities. These are your financial priorities. Second, budget for your savings and debt payoff. Last, budget for everything else. This includes eating out, personal care, memberships, gifts, etc.
Once your budget is done, don’t just toss it to the side; check it every day. Track your spending and stop when you realize you’ve hit your limit in a category.
3. Attack your debt
Your debt is one of the biggest obstacles to financial freedom. The sooner you can eliminate it, the better off you'll be.
First, figure out how much you owe and what your interest rates are so that you know what kind of damage they're doing to your finances. Then start paying them off as quickly as possible by making extra payments whenever possible or taking on side jobs if necessary.
Start small and build up to paying off your largest debt; this is the debt snowball. That’s ordering your debts from smallest to largest and paying off the smallest first and working up to paying off your largest debt. Trust me, it works!
4. Get a second job
Getting a second job is one of the easiest strategies to pay off debt rapidly. This way, you'll be able to put more money towards your bills and pay them off faster. Some second job ideas are:
- Drive Uber or Lyft
- Work part-time at Amazon
- Sell refurbished furniture
- Start an Etsy shop or Amazon FBA
- Tutor students online
Debt does not have to be your master. Instead, the more you understand it, the more you can control it.
I hope this has helped you understand the types of debt and most importantly how to pay it off.