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Debt, debt, debt - it's a word we hear so often, and honestly hate hearing, but what does it really mean and how does it affect the rest of finances?
Unfortunately, it's a part of everyone's life - unless you live off the grid, never went to college, paid with a credit card, taken out a loan or financed a car, you more than likely have some sort of consumer debt in your back pocket.
What is debt?
Let's look at it like this, debt is a bucket - a category that different types of money are organized into. To put it bluntly, debt is money that isn't yours in the same way that income from your paycheck is yours. A debt is borrowed funds from a lender, that you return by making a monthly payment with interest, so now that you know the overarching definition of debt, we can get into the various types of debt in more detail.
You can calculate your debt a few different ways, but I have a helpful debt calculator that breaks it down for you so you don't have to do all the math. This can help you get a jumpstart on understanding your debt.
Types of debt
There are really four different types of debt, but let's get one thing straight - all debt is technically bad debt, in the sense that it does affect your credit and the rest of your personal finances going forward, even if you are responsible with it. At face value, taking on debt in order to remain stable on required payments can seem like a great idea, but even missing a single payment can have affects on your credit in different ways.
Unsecured debt is debt that the bank doesn't have any collateral to secure the loan - meaning their only security is that you promise to pay the money back. These are things like personal loans, credit cards, student loans, and other loans in which there is nothing for the bank to take back if you fair to repay the debts by a certain date.
Unsecured debt is the type that lenders don't like to approve very often unless the borrower's creditworthiness (the eligibility one has to receive and pay back debt) is high and the lender is confident in the ability for the borrower to repay the loan.
Secured is a little bit different than unsecured in the sense that the lender does have collateral as a way to secure the loan. When you think of secured, think about financing a car, car loans, or your mortgage. These are secured with either a vehicle or a house, something the bank can take back if a borrower fails to make payments.
With this type, if you fail to make payments, the lender will take back what you "borrowed" and sell it in order to get the money the lent to you back - whereas you are then still required to pay the money back to the lender. With secured loans, the interest rate tends to be a little lower than that of the unsecured, because the bank has that collateral.
Revolving debt is credit cards, one of the most common forms of debt. It's considered revolving because instead of getting a lump sum of money that you then have to pay back, revolving allows you to continue to borrow from that total amount, as long as you are making monthly payments.
Revolving debt can get you into trouble because depending on the credit limit of this credit, it could be very hard to pay back if you're not caught up or keeping up with payments. With these loans, it is incredibly important to prioritize this debt owed and your credit utilization ratio (how much you are using compared to how much is available).
Non-revolving debt is pretty straightforward, this is money owed that is given out in one lump sum, so your mortgage or car are examples of this.
Typically when you think of such debts, large purchases like cars and homes come to mind, but in reality, places are always trying to encourage you to pay things using credit. Think about shopping online, and you see the Klarna or AfterPay section when you go to checkout, these are "lenders" that are essentially lending you the money you need to buy the product and you pay them back in monthly installments over time. So, it's important to really think about what you are financing or getting a personal loan for, as all of them have affects on your finances.
Common terms surrounding debt
Debt can become even more complex when terms are being thrown around and you're not sure what they mean, or how they work. As the borrower of funds, it's crucial to understand the terms, in's and out's of deb to be the most prepared and confident when taking new debt. Let's go over some common terms in the finance and debt-world to help raise your understanding.
- Interest: the cost of borrowing money - what you pay in addition to the monthly payment, for borrowing the money in the first place. Typically this is a percentage of the total amount you borrowed.
- Interest rate: the proportion of the loan that is charged as interest. This is the percentage of the total amount borrowed we mentioned above.
- Mortgage: this is a home loan, or borrowed money used to buy a house.
- Debt consolidation: taking out a new loan or line of credit to pay off other loans or lines of credit creating one monthly payment instead of multiple.
- Consumer debt: the general concept of having debts that you owe - in other words all of your personal debts fall into this bucket.
- Federal student loans: loans taken out from the government for college education.
- Debt level: the measure for how much outstanding debt an individual, business or country has.
- Collateral: something that the loan is taken out "against", by which if the borrower fails to repay, like an auto loan, the lender or bank can take back that collateral.
- Personal loan: any amount borrowed for a variety of purposes including student loans, large purchases that aren't home or auto loans.
The bad and ugly of debt
Despite what you may think, or what banks tell you, debt is debt - no matter how you get it or what you use it for, it's money owed that needs to be paid back, including interest.
No matter what, debt restricts where your income can go when you get that paycheck, because that money you borrow needs to be paid back. So, when you get your paycheck, that's the first thing it typically goes to and you have little left over. Thankfully, there are ways to help you payoff debt to free up your income as well as help you build a future. There is not a lot that debt does for you that's positive, apart from build your credit.
So, we've covered the questions "what is debt" and chalked it up to but when you borrow money for a purchase and are required to pay back that money while making additional interest payments. We covered that there are various types including secured, unsecured, revolving and non-revolving - which have different affects on your personal finances.
The biggest part of building a future of wealth for yourself and for your family is by understanding your financial situation, being able to pay off your debts, responsibly manage your income, and save for retirement. In order to make these things happen, limiting your debt is number one.