What Are the Different Types of Debt?
Over your lifetime, you’ll probably use various types of debt for different purposes. Here are the key features of the main types of debt.
By Frances Coppola | American Express Credit Intel Freelance Contributor
4 Min Read | October 28, 2020 in Money
Personal debt falls into two broad types – secured and unsecured – and two main repayment approaches – revolving and installment.
Common types of secured debt are mortgages, which come with tax advantages, and car loans, which don’t.
Unsecured debt generally includes student loans, credit cards, medical bills, personal loans, and even gym memberships.
On-time payments and a good mix of debt types can boost your credit score.
Over your lifetime, you’ll probably borrow many times for different purposes. At some point you may find yourself juggling various types of long-term debt: a student loan, a mortgage, a car loan, a credit card, a line of credit. Understanding the basics of different types of debt can help you manage today’s complex financial landscape. Let’s look at the key features underlying several common types of debt and what they can mean for your finances.
Basically, you can think of any individual personal debt as combining one of two broad categories of debt with one of two repayment strategies. The two broad categories of debt are:
- Secured debt: You offer some form of property that the lender can take if the loan defaults.
- Unsecured debt: You get the loan based on your good name and credit score.
The two main repayment strategies for personal debt are:
- Revolving debt: You get a maximum credit limit up to which you can borrow, repay, and borrow again – so the balance you owe “revolves.” But you’re not obligated to borrow anything.
- Installment debt: You get the money upfront and repay it in regular payments, typically monthly, over the course of an agreed number of months or years. “Balloon” repayment is a variation in which you don’t repay any of the money you’ve borrowed until the loan expires, though you might make interest payments along the way.
In other words, you could have secured revolving debt, unsecured revolving debt, secured installment debt, or unsecured installment debt.
If a loan is “secured,” it means that you have pledged some of your property as collateral in return for the money you borrow. If you don’t pay back the money by the time it’s due, or you miss payments along the way, the lender has the right to take your property. Secured debts generally have lower interest rates than unsecured because collateral lowers the lender’s risk. Also, in general, the longer your loan term the lower the interest rate.
Mortgages and car loans are among the most common types of personal secured debt in the U.S. – the property that is pledged as collateral is your house or car. Most mortgages and car loans have interest rates fixed for the duration of the loan, although some adjustable-rate mortgages are available. Interest on mortgages is usually tax-deductible, while interest on car loans is not.
Unsecured debt includes most student loans, credit cards, bank overdrafts, medical bills, personal loans, and even gym memberships for which you sign a contract to pay. You don’t pledge property as collateral, but your lender will check your credit history and income before advancing the loan. Interest rates, therefore, tend to be higher for these loans than for secured loans, and are seldom or only partly tax-deductible.
Student loans are a special type of unsecured debt. They are usually owed to the federal government, though there are also private student loan providers. Federal student loans are typically offered at a low, fixed interest rate and are paid down over a lengthy period of time, while private loans might offer terms with either fixed or variable rates.1
Credit cards and bank overdrafts are types of unsecured debt that are also forms of revolving credit. Rather than borrowing an amount of money upfront which you gradually pay down, you agree with your lender on an amount that you may borrow but are not obliged to. This is sometimes called a “facility” or a “line of credit.” The maximum amount you can borrow is your “credit limit.” If you do choose to borrow, you can continuously repay and re-borrow against your credit line as long as you stay below your credit limit and continue to make at least the minimum payments on time.
You might have to pay an annual fee to maintain the facility, but you only pay interest on the amount that you actually borrow, which might be considerably less than your credit limit. And in the case of credit card debt, you can usually avoid interest altogether if you pay your monthly statement balance in full and on time. If you exceed the limit on your credit card or bank overdraft, you typically can’t borrow any more without incurring penalty charges. But when you’ve paid off some of the outstanding balance, you can then borrow again. This is why this type of debt is known as “revolving credit.”
While most revolving credit is unsecured credit card debt, there are two useful examples of secured revolving credit. Certain credit cards are secured by a deposit equal to the credit limit, and home equity lines of credit (HELOCs) are secured by your home.
Revolving credit can help you improve your credit score. A history of on-time payments plays a major role in credit scores, and revolving credit gives you an opportunity to build such a history. Maintaining your balance at or below 30% of your credit limit is also important to your score. For more, read “What Affects Your Credit Score.”
Other than credit cards and lines of credit, secured and unsecured debt usually come in the form of “installment loans” where you borrow all the money upfront and pay it back in regular installments, usually monthly. In most installment loans, the payments include both interest and principal, with the portion going toward interest starting high and diminishing over time. Some, however, may require you pay interest only, in which case there will be a “balloon” repayment of the principal when the loan expires.