How to Squish These Four Types of Debt
You may want to know the difference between secured debt, unsecured debt, revolving debt, and installment debt because it helps you understand the consequences if you forget to make a payment. Or worse, it helps you understand the consequences if you decide not to make your payments at all. Let's take a quick look at these four debt types and how to handle them.
Did you know that your credit card falls into a specific category of debt called "revolving" debt and your mortgage goes into a debt category called "secured" debt?
Maybe you really don't care at all — you just know that the debt you have costs you money every month.
However, you may want to know the difference between secured debt, unsecured debt, revolving debt, and installment debt because it helps you understand the consequences if you forget to make a payment. Or worse, it helps you understand the consequences if you decide not to make your payments at all. Let's take a quick look at these four debt types and how to handle them.
What is Secured Debt?
When you take on secured debt, you've chosen a type of debt backed by collateral you own. In other words, when you borrow from the bank to buy a home or a car, you don't own whatever it is that you bought — the bank does. The bank puts a financial claim on your property with something called a lien.
Furthermore, the bank can take it away if you stop making your payments. Let's say you decide to build a beautiful 3,000-square foot home. You can make your payments, no problem. However, let's say you lose your job two years down the road and your partner must struggle to make the payments alone (and buy the kids new shoes and groceries to boot) while you look for a new job. If you can't make your mortgage payments, a bank can seize your home, sell it, and use the proceeds from the sale of your home to pay back the debt.
What is Unsecured Debt?
Unsecured debt, as you might imagine, does not involve collateral. In other words, you don't have to pony up something you own in order to borrow.
Can you think of a great example of an unsecured debt?
If student loans popped into your head, great job. The pesky remnants of a degree you got years ago (in the form of student loan debt) offers a great example of an unsecured debt. You can consider student loans unsecured debt because if you stop making your student loan payments, your lender can't take your degree away.
So, because your lender cannot seize your assets, what can it do if you suddenly stop making payments on your unsecured debt? Your creditor can contact you to get payment, report your delinquency to a credit reporting agency or file a lawsuit against you.
Since your lender's risk naturally increases with unsecured debt, you might imagine that there's a catch. You're right: Interest rates on unsecured debt is usually higher in comparison to secured debt, and typically ranges between 5% and 36%.
What is Revolving Debt?
Revolving debt, sometimes called a line of credit, means that you can borrow money repeatedly up to a set dollar limit. You may think of credit card debt as the most common example of revolving debt. Other types of revolving debt include personal lines of credit and home equity lines of credit (HELOCs).
Here's how revolving debt works: You make payments each month based on your outstanding balance for that particular month — you must make at least the minimum payment. An interest charge may get added to the balance that you carry over from month to month. (Unless your credit card or line of credit offers you an introductory 0% interest period.) As you repay more of what you owe, you free up more of your credit line as you go.
You may also have to pay annual fees, origination fees or fees for missed or late payments when you sign up for revolving debt.
What is Installment (Nonrevolving) Debt?
Just to make sure we covered the flip side of revolving debt (even though it overlaps with other types of debt), we'll also cover nonrevolving debt. You can't use a nonrevolving loan more than once. Once you get the loan, you can't get it again.
Non-revolving debt is also known as installment debt because you typically repay it in regular monthly installments until a specific, predetermined date in the future. Unlike revolving debt, you cannot "replenish" your credit line every month.
Can you think of some examples of installment loans?
Mortgages, auto loans, student loans and personal loans exactly fit into these categories. Note the tricky part of the puzzle: These types of loans can categorize into either unsecured or secured loans! For example, you can consider a student loan debt unsecured installment debt but you'd consider a mortgage in the "secured installment debt" category. On the other hand, you'd put credit cards into the "unsecured revolving debt" category. Personal loans go into the "unsecured installment debt" category.
How to Handle These Types of Debt
You might chuckle because you know the answer to handling these types of debt — get rid of them by paying them off!
However, it might not seem that easy, particularly if you have a lot of different types of debt. Which type should you tackle first? For example, if you have a personal loan, a student loan and a HELOC, which one should you put your efforts toward paying off first?
First and foremost, consider which debt is backed by your own assets. What type of collateral do you risk losing if you don't make your payments on time?
Remember, if you fall behind on payments for a secured debt, you could lose your house or car. Whatever you do, make sure you make all of your debt payments, especially those backed by collateral!
Then, you may want to pay more on other types of debt based on:
- Your emotions and feelings toward a specific debt
- The highest interest rate
- The amount of debt you have (the debt with the highest number)
Think the first bullet point seems a little strange? Truthfully, how you tackle your debt might not even make sense to anyone else, even your financial advisor. However, if you have a real issue regarding your student loan debt, it might make sense to get rid of it first, even if it's not your highest interest rate or the highest amount of debt you have.
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