Everything You Need To Know About Debt

Debt is a fundamental aspect of modern finance, affecting daily spending and long-term financial planning. This guide covers various types of debt, both good and bad, and their effects on our lives. Financial experts provide practical tips on escaping debt and share real-life success stories.

What Is Debt?

Debt is money one party borrows from another, usually through loans or credit. Repayment terms typically include principal plus interest. Understanding debt is crucial to your financial well-being. Debt can help you become a homeowner or send you into a spiral. It depends how you use it.

Common Types of Debt

Different types of debt include secured debt, backed by collateral, and unsecured debt, which doesn’t require collateral. Common categories are consumer debt, mortgages, auto loans, student loans, business debt, medical debt and tax debt.

Secured vs. Unsecured Debt

This important distinction explains what you may qualify for and the interest you’ll pay. Here’s the difference:

• Secured debt is backed by collateral, or something the lender can take if you don’t pay. Home mortgages and auto loans are secured debts because an asset backs them.

• Unsecured debt doesn’t require collateral. Credit cards and personal loans are common types. Depending on your credit and income, unsecured debt often comes with higher interest rates than secured debt.

Consumer Debt

Consumer debt refers to personal financial obligations incurred through borrowing:

• Credit Card Debt: Credit cards allow you to borrow up to a set limit. You incur interest charges if you don’t pay off the balance monthly. Some people max out their credit cards, creating a big problem for themselves. (See our guide on how to pay off credit card debt.)
• Personal Loans: These are lump-sum loans repaid over time with fixed monthly payments. You can use them for various purposes, such as debt consolidation or home improvements. Some people use them to pay off credit card debt at a lower interest rate. But you still have the same total amount of debt.
• Payday Loans: High-interest lenders provide these to people who often have no other options. These can lead to debt cycles due to their high costs. These are a last resort for borrowers. They’re a signal of unstable finances.

Mortgages

Mortgages are loans used to buy real estate:

• Fixed-Rate Mortgages: This home loan has a fixed interest rate through the loan term, often 30 years, providing predictable monthly payments.
• Adjustable-Rate Mortgages (ARMs): The interest rate can change periodically based on market conditions, affecting your monthly payments.
• Interest-Only Mortgages: You pay only the interest for a set period, then start paying both interest and principal. These can be risky if property values decrease.

Auto Loans

Auto loans finance the purchase of vehicles:

• New Car Loans: Loans for buying new vehicles typically offer lower interest rates because of the vehicle’s higher initial value.
• Used Car Loans: Loans for purchasing pre-owned vehicles often come with higher interest rates because used cars have a lower resale value.
• Refinanced Auto Loans: Refinancing replaces your current auto loan with a new one, ideally with better terms or a lower interest rate.

Student Loans

Student loans help finance higher education:

• Federal Student Loans: These government loans have fixed interest rates, income-based repayment and potential loan forgiveness.
• Private Student Loans: Issued by private lenders, these loans often have higher interest rates and fewer repayment options compared to federal loans.

Business Debt

Businesses borrow money to fund operations, expansion and equipment:

• Term Loans: These are lump-sum loans repaid over a fixed period, often used for significant investments or expansion projects.
• Lines of Credit: These are Flexible borrowing options up to a set limit, useful for managing cash flow or unexpected expenses.
• Equipment Financing: Businesses use these loans to buy equipment, which often serves as collateral.

Medical Debt

Medical debt arises from health care expenses not covered by insurance:

• Causes of Medical Debt: High medical costs, unexpected emergencies and lack of adequate insurance can lead to significant medical debt.
• Strategies for Managing Medical Debt: Negotiating with healthcare providers, setting up payment plans, and seeking financial assistance can help manage medical debt.

Tax Debt

Tax debt occurs when you owe back taxes to the government:

• Understanding Tax Debt: Unpaid taxes can accrue interest and penalties, making it essential to address tax debt promptly.
• Options for Resolving Tax Debt: Payment plans with the IRS, offers in compromise and seeking help from tax professionals are common solutions.

Key Stats About Debt in 2024

1. Average Household Debt: As of 2024, the average U.S. household debt is approximately $145,000, encompassing mortgages, auto loans, student loans and credit card debt.
2. Credit Card Debt: The average American carries about $6,200 in credit card debt.
3. Student Loans: Total student loan debt in the U.S. has surpassed $1.7 trillion, with the average borrower owing around $37,000.
4. Mortgage Debt: The total mortgage debt in the U.S. is over $10 trillion, with the average mortgage balance per household being approximately $210,000.
5. Auto Loans: The total outstanding auto loan debt in the U.S. is about $1.4 trillion, with the average new car loan amount around $36,000.
6. Delinquency Rates: Approximately 4% of all consumer debt is delinquent, with credit cards having a higher delinquency rate of around 8%.

How To Manage Different Types of Debt

Two popular, effective debt payoff methods include the debt snowball method, which prioritizes paying off small debts first, and the debt avalanche method, which focuses on high-interest debts.

The Debt Snowball Method

The debt snowball method starts with paying your smallest debts first while making minimum payments on larger ones. Here’s how it works:

• List Your Debts: Arrange your debts from smallest to largest.
• Pay Off the Smallest Debt: Allocate extra funds to pay off the smallest debt as quickly as possible.
• Move to the Next Debt: Once the smallest debt is paid off, apply the funds previously used for it to the next smallest debt.
• Repeat the Process: Continue this method until all debts are paid off.

The Debt Avalanche Method

The debt avalanche method prioritizes paying off debts with the highest interest rates first. Here’s how it works:

• List Your Debts: Arrange your debts from highest to lowest interest rate.
• Pay Off the Highest Interest Debt: Focus extra funds on paying off the debt with the highest interest rate first while making minimum payments on others.
• Move to the Next Highest Interest Debt: Once the highest interest debt is paid off, apply the funds to the next highest interest debt.
• Repeat the Process: Continue until all debts are paid off.

Other Ways to Manage Debt

Here’s a look at other approaches to debt management:

• Debt consolidation involves combining multiple debts into one. This can simplify payments and potentially lower interest rates. Options include personal loans, balance transfer credit cards and home equity loans. Benefits include simplified payments and possibly lower interest rates. However, it can lead to longer repayment periods and requires discipline to avoid accruing new debt. (See our TPH guide to the best debt consolidation loans.)
• Debt refinancing means replacing an existing loan with a new one, ideally with better terms. This can lower your interest rate and monthly payments, making debt more manageable. While refinancing can save money, it might extend the loan term and increase the total interest paid over time.
• Credit counseling services are non-profit organizations that offer budgeting advice, debt management plans and financial education.
• Private financial advisors also can help you get out of debt with more personalized advice.
• Debt settlement programs involve companies like Freedom Debt Relief or National Debt Relief, which negotiate with creditors to reduce your total debt. This can negatively impact your credit score and should be a last resort.
• Bankruptcy options are Chapter 7 and Chapter 13, which offer different ways to manage or discharge debt. Chapter 7 involves liquidating assets to pay off debt, while Chapter 13 reorganizes debt into a manageable repayment plan.

Impact of Debt on Credit Score

Debt affects your credit score through payment history, credit utilization ratio and the length of your credit history. Timely payments and managing credit utilization can help maintain a good score.

How Debt Affects Your Credit Score

Your credit score reflects your debt management skills:

• Payment History: Timely payments boost your score, while late or missed payments can significantly lower it.
• Credit Utilization Ratio: Using a high percentage of your available credit can negatively impact your score. Aim to keep this ratio below 30%.
• Length of Credit History: Longer credit histories generally improve your score, showing lenders that you have experience managing credit.

Tips for Maintaining a Healthy Credit Score

Maintaining a good credit score involves:

• Timely Payments: Always pay bills on time to maintain a positive payment history.
• Managing Credit Utilization: Keep your credit card balances low relative to your credit limits.
• Monitoring Credit Reports: Regularly check your credit reports for errors and dispute inaccuracies promptly.

Rebuilding Credit After Debt

If your credit score has suffered, you can rebuild it:

• Steps to Rebuild Credit: Make consistent, on-time payments, reduce outstanding debt and avoid applying for new credit frequently.
• Timeframes for Credit Recovery: Rebuilding credit typically takes several months to a few years, depending on the severity of past issues.

Benefits and Risks of Taking on Debt

Debt can have advantages. This is known as good debt, which typically involves borrowing for investments that grow in value, such as education or real estate. In contrast, bad debt often involves high-interest loans for depreciating assets or unnecessary expenses. Any debt can potentially become bad if it exceeds your budget.

Characteristics of Good Debt

Good debt is generally considered an investment in your future:

• Investment Potential: Loans for education, home purchases, or business ventures can yield returns that exceed the cost of borrowing.
• Asset Acquisition: Good debt helps acquire assets that appreciate over time, such as real estate or a degree.

Characteristics of Bad Debt

Bad debt often offers little to no long-term value:

• High Interest Rates: Credit cards and payday loans have high-interest rates that can quickly escalate debt.
• Lack of Long-Term Value: Borrowing for depreciating assets or unnecessary expenses can lead to financial instability.

Examples of Good and Bad Debt

• Good Debt: Mortgages, student loans, business loans.
• Bad Debt: High-interest credit card debt, payday loans, financing for luxury items that quickly lose value.

Conclusion

There are several types of debt, including secured and unsecured, but most of the time people fall into it because of the following reasons: 

1. Unexpected Expenses
2. Job Loss or Reduced Income
3. Poor Financial Management
4. High-Interest Debt
5. Living Beyond Your Means

Debt can be a good thing. If you use it to add value to your life, such as taking out a loan to pay for a degree that advances your career, it can qualify as good debt. But debt can quickly become bad debt if you take on too much or it has high interest rates. Popular methods such as the snowball method or the avalanche method can help you tackle debt.