Debt has its own jargon and lingo. This can make an already complex topic seem overwhelming. Fundamentally we can break down debt into types based on characteristics and usage, making debt more understandable.
We should first distinguish between credit and debt, which are not the same. The word credit has multiple uses in business and finance; for our purposes we need consider only one.
From the standpoint of personal finance and the lending or borrowing of money, credit is an amount a lender makes available for you to borrow. For example, credit cards are issued with a credit line, the amount of money you can charge with the card.
The credit limit is the amount you can borrow, but there is no debt until you use the card. Debt is the principal amount you owe. Initially it is the amount you borrowed, but the debt declines as you pay it back.
Types of Debt
Debt generally falls into one of four categories: secured, unsecured, revolving, and mortgage.
Secured debt is backed by an asset you have pledged as collateral for the loan. This could be an automobile in the case of an auto loan, or it could be another asset securing a loan, such as stock or a certificate of deposit.
Secured debt is less risky for the lender — if you fail to make your payments, the lender can take your collateral. Secured debt typically has lower interest rates than comparable unsecured debt due to its lower risk to the lender.
Unsecured debt is guaranteed only by your promise to pay. Credit card debt is typically unsecured; the borrower generally does not put up any assets as collateral for the debt. Unsecured debt has more risk for the lender; lenders tend to charge interest at higher rates to offset their higher risk.
Revolving debt is open ended: The borrower can continue to borrow and pay back on an ongoing basis. Credit card debt is the most common form of revolving debt; the credit remains available for you to borrow again and again as you pay back what you previously borrowed.
Mortgages are a form of secured debt, but warrant their own category due to the unique characteristics of this form of debt. A mortgage is typically the largest debt a person will ever assume in their lifetime.
Forms of Debt and Their Uses
The types of debt are used for different purposes. Each affects a person’s finances differently: Some can be beneficial to their long-term financial health; others frequently tend to be harmful. There is a tendency to define debt as “good” or “bad,” but that nomenclature is not absolute.
Debt is inanimate; it does not do bad things to you unless you invite it to do so. It is not the instrument that causes the problem; it is the use of the instrument that causes the problem. If there were ever an appropriate place to use the expression “too much of a good thing,” debt would be it.
Mortgage Debt
Mortgages allow people to purchase a home instead of renting. In many cases, a person or a couple can buy a home for less than they could rent an equivalent place across a long period of time.
It doesn’t always make sense to buy, but it frequently does if you are going to stay in one area for a long period of time.
Rents go up. Inflation makes them go up even more. Purchasing a home stabilizes the largest portion of housing costs. There are still costs that go up when you own a home: Real estate taxes trend upward maintenance and upkeep likewise trend upward.
Mortgage debt can help people get ahead financially when used correctly. Most people could never save enough to purchase their home without using debt.
Many others could do so only by resorting to extreme frugality for an extended period. Homes increase in value, and saving in advance for a home is not good mainstream advice. It works for a few but not for most.
Student Loans
Student loans are a type of unsecured debt. They are used to enable people to afford education they might not otherwise be able to afford. This works out well for many people; they are able to get a degree they wouldn’t otherwise be able to get, and subsequently be able to obtain a high-paying job they wouldn’t have otherwise been able to get.
For others, this doesn’t go so well. Some people start college and don’t finish, ending up with loans but no high-paying job. Others do finish, but are not able to find lucrative employment.
For those considering student loans, there should be careful analysis of the cost and benefits of college debt. Unfortunately this decision usually falls to someone who is emotionally engaged in the decision and lacks experience in making these types of decisions. If there is one aspect of student loans that begs for improvement, loan counseling is it.
Auto Loans
The biggest problem with auto loans is not that people use them to buy cars, but that they use them to buy cars they can’t afford.
In our society, many people need to have cars to get to work and other places. Mass transit is not, nor will be, an option. It may be in some urban centers, but not in most of the United States. Car ownership is a necessity for many people.
People often buy the car they want instead of the car they need. They might, for example, purchase a large gas-guzzling pickup truck when they have a lengthy commute and little or no need for such a utility vehicle. Cars are a place where buyers often make emotional decisions and suffer financial consequences as a result.
Auto loans are a necessity for many people. But they need not be in the long run. It may be necessary to use a loan to buy a car you need now, but not the one you need five or seven years from now.
Do what you need to do today, but take the steps so you don’t need to take a loan again next time. And buy only what you need. That could mean a used car, or it could mean an efficient car.
Other Installment Debt
Other installment debt is used for purchases that generally fall into the category of “wants” not “needs.” Installment debt is often used for purchases such as boats, RVs, and airplanes. It is also — unfortunately — often used for purchases such as televisions.
If you are on track for all your long-term financial goals and have excess money, there is nothing wrong with having a boat or an RV or an airplane.
The key is to be on track for all of your long-term goals first. It is not financially prudent to use debt to make these types of purchases unless you are on track for all of your goals. And it is difficult to imagine a situation where it would ever be prudent to use debt to buy a TV.
Credit Card Debt
Credit cards are a necessity in our society. We buy things online, and we need a way to pay for them. It is not safe to carry the amount of cash we need for some purchases; carrying credit cards has a lot less risk.
Credit cards are the primary reason for many people’s financial problems. They can be a useful tool, or they can put us into debt we may not easily get out of.
The problem isn’t the cards — it is how they are used. Credit cards should not be used to fund consumer purchases or to fund a lifestyle. Credit cards should not be used to purchase things we couldn’t afford to otherwise pay for. They should be a matter of convenience, not a source of debt.
Credit should make life easier, not more difficult. If you are unable to pay your credit card balances each month, you should seriously consider getting rid of your cards. They are no longer being used as they should be used; they are hurting you not helping you.
If you have a toxic relationship with credit cards, you should end the relationship.
The Bottom Line
There are forms of debt not addressed above, and these should be considered on a case by case basis, such as medical debt.
Though buy now pay later (BNPL) isn’t addressed here, it should be viewed like credit card debt. From a practical standpoint, BNPL is a debt without interest, but a debt that is typically for a want, not a need. And we never need to go into debt for a want.
Debt can be used to your financial advantage if used appropriately and sparingly.
Debt is appropriate typically with secured debt, where you are purchasing an asset; unsecured debt is rarely financially advantageous.
Most people can’t live their whole lives without debt; that’s just not practical. We can, however, move in that direction.
We need to have a mortgage to buy a house, but we should pay off that mortgage as soon as we practically can. We may need a car loan to buy a car when we are young; as we advance in our careers and build financial resources, we should work toward a place where we no longer need to borrow to buy a car.
Debt doesn’t cause problems without human intervention. It doesn’t take over your life unless you take on more types of debt than you should have.
Debt also won’t go away without human intervention. If you have a debt problem, it should be addressed as soon as possible. It won’t get better on its own. Understanding debt and using it appropriately — and sparingly — can help prevent unnecessary debt problems.
