Understanding and Resolving Common Types of Debt

Guest Post by Lyle Solomon

Most of us will incur debt at least once in our lifetime, be it student loans, mortgage, or credit card debt. Depending on your financial situation, debt can be good or bad. However, all debts are not the same, therefore managing these debts is not the same. 

Mainly, there are two types of debt: secured and unsecured debt, with other subtypes of debt coming under each or both. It's essential to understand how each kind of debt works, if you'll be able to manage it along with the rest of your obligations, and how it can affect you. 

What is debt?

Debt is defined as something, usually, money, loaned from one party by another. Many corporations and individuals use debt to make large purchases that they would not be able to make under normal circumstances. A debt agreement allows the borrowing party to borrow money on the condition that it be paid back later, generally with interest.

Let's understand the different types of debt: 

Secured debt

A secured loan is one backed by tangible assets. A credit check is essential to obtain a secured loan since it determines the borrower's repayment capabilities. If the borrower doesn't pay back the loan, the lender is protected by collateralized assets. The property can be seized by the lender if a loan is not repaid on time. If the confiscated collateral does not pay the entire debt, the creditor can sue you to reclaim the remaining amounts.

Secured loans can help you acquire a large loan. The lenders know they will be paid back because of the collateral. Secured loans offer lower risks for lenders than unsecured loans, so you may be able to acquire a low-interest rate.

Examples of secured debts:

• Mortgage
• Home Equity Line of Credit (HELOC)
• Installment loan
• Car financing
• Revolving credit

Unsecured loans 

Unsecured loans are loans that you can get without any collateral. Loans without collateral are made solely based on a borrower's ability to repay and their promise to do so. In an unsecured loan, you don't have the risk of losing any of your assets. Lenders review a person's credit record to see if they qualify for a loan. 

But not all debts are equal. Lenders analyze your payment history, current debts, credit scores, total income, debt-to-income ratio, etc. In general, a higher credit score means more options. A good credit score can earn you a low-interest loan. As a result, unsecured loans are granted faster than secured loans.

However, it may be challenging to get approved if you don't have a good credit score or credit history. Even if you get approved, you might get a higher interest rate.

Examples of unsecured loans:

• Most credit cards
• Student loans
• Personal loans
• Payday loans
• Medical bills
• Installment loans
• Revolving credit

Debts that are both secured and unsecured

A few debts fall under both secured and unsecured loan categories. These loans are referred to by different names in each major category.

Revolving debt

Revolving debts are open lines of credit. Here, you borrow up to a certain amount, also known as a credit limit. You can keep borrowing from that line of credit as long as you make the minimum monthly payments. The best example of an unsecured line of credit is a credit card, and a secured loan is a home equity line of credit.

Installment debt

When a loan is paid back in regular installments, it is called an installment debt. Payments are usually made in equal monthly installments, with one part being interest and the other part being the principal amount. As this is also known as an amortized loan, the lender must create an amortization schedule outlining the payments made over the life of the loan. 

Customers prefer installment loans for bigger purchases such as homes, cars, and electronics. Lenders like installment debt because it provides a consistent flow of cash to the issuer over the life of the loan, with monthly installments based on a predetermined amortization schedule.

Best ways to handle debt

A single debt might be intimidating, but having many debts can be even more stressful. Debt management can become a challenge if there is no understanding or planning in place.

Budgeting and debt management to pay off debt can be done in various ways. Let's explore a few of them:

Budgeting

If you have a favorable debt-to-income ratio, budgeting may help you better manage your debts. The best way to make a budget is by dividing your income into three portions: 

• 50% of your income is for your needs. Rent/mortgage, car loan payment, insurance, health care, groceries, debt payments, and utilities fall into your "need" category; these are your essentials. This category may also include your "must-haves" like Netflix, takeout, coffee from Starbucks, indulgences, etc. 
• 30% of your income is for your wants. Your wants or non-essentials include going out to eat, seeing a movie or sporting event, taking a trip, purchasing a newly released device, purchasing designer clothing and shoes, or joining a gym. Even though they are wants, you are not dependent on them.
• 20% of your income is for your savings. This last 20% of your income goes into your emergency fund, mutual funds, IRA contributions, investments, etc. This portion of your money helps you build more money. 

Debt consolidation

When you are stuck with multiple debts and don't know how to manage all of them, debt consolidation is your friend. Debt consolidation uses numerous forms of financing to pay off your debts and liabilities, such as taking out a new loan to pay off existing debts.

Multiple debts are frequently combined into a single larger debt, such as a personal loan, with more desirable repayment terms, such as a lower interest rate, a lower monthly payment, or both. You can consolidate credit card debt, student loan debt, payday loan debt, mortgage payments, etc.

You can do debt consolidation through any of the following options: 

• Balance transfer card
• Debt consolidation loan
• Debt consolidation program

Debt management

A debt management plan can be useful to help you pay off your debt. A debt management plan's goal is to reduce the debt's interest rate and monthly payment amount, as well as to assist you in creating a budget to accommodate the payments. You can receive debt management plans from non-profit or for-profit credit counselors. 

Credit counselors work on your behalf to negotiate lower interest rates and lower monthly payments with your creditors. A debt management strategy is often a component of a larger debt reduction strategy, such as a debt consolidation strategy.

Three cardinal rules to follow when repaying debt

1. Never be late on your payments
2. Do not miss any payments
3. Always pay a little bit more than the monthly payment amount

The bottom line

Knowing and understanding the different types of debt can help you manage your finances better in the long run. You have a choice: either you let your money control you, or you take charge of your financial situation and manage it effectively. The main distinction you have to figure out is which debt suits you best. You should always do research and have a plan to handle the debt before you sign the dotted line. 

Lyle Solomon has extensive legal experience as well as in-depth knowledge and experience in consumer finance and writing. He has been a member of the California State Bar since 2003. He graduated from the University of the Pacific's McGeorge School of Law in Sacramento, California, in 1998, and currently works for the Oak View Law Group in California as a principal attorney.