Debt 101: Knowing the Basic Types of Debt | FaithFi
Debt 101: Knowing the Basic Types of Debt
By GuideStone
January 6, 2025
Debt is a legal obligation to pay back money borrowed, and the decision to enter into it should not be taken lightly.
Debt is a legal obligation to pay back money borrowed, and the decision to enter into it should not be taken lightly. You are committing a portion of your and your family’s financial resources to someone else, which can impact your daily living and future goals of saving and retirement.
When used wisely, debt may be a helpful tool for reaching some of your goals. However, if managed carelessly or taken on without understanding all its terms and implications, it can lead to financial instability and even ruin.
When considering going into debt, it’s essential first to understand some basic concepts:
The principal is the amount borrowed.
Interest is the cost you pay the lender for borrowing money, usually calculated as a percentage of the principal.
In most cases, debt is paid back in installments or regular, fixed payments (usually monthly) over a set period. These payments are comprised of a portion of the principal and interest.
The repayment period is how long you have to pay the loan back. The longer the repayment period, the more interest will accrue, leading to higher total repayment amounts.
A secured loan is backed by collateral or the pledge of an asset to cover the loan in case of default.
An unsecured loan requires no collateral but typically carries higher interest rates since the lender assumes more risk.
Revolving credit allows you to borrow up to a predetermined amount, repay it and borrow again as long as you stay within your credit limit. You can repay the balance in full or make regular (but not necessarily fixed) payments.
There are several types of debt that serve different purposes, but each can present significant challenges if not managed wisely. Below are the seven most common types of debt:
When deciding whether to take on debt, be sure that you understand the long-term implications of any financial commitments you make and balance borrowing with the ability to repay. Remember, missing payments or defaulting on your loan can result in collateral loss, severely damage your credit score, and face debt collection fees, wage garnishments, property seizures or other legal action.
Looking for more help? Check out our helpful resources and calculators. Also, browse and watch our webinars for tips on money management and good financial stewardship for additional guidance in handling your financial resources wisely.
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Mortgages are used to finance the purchase of a home or real estate. Banks and mortgage companies are the most common lenders. These are secured loans since the purchased property is used as collateral. Mortgages require a significant down payment and a good credit history. Taking out a mortgage is a long-term commitment as they typically span 15 to 30 years. Should the property value decline over the life of the mortgage, you could owe more than the property is worth. If enough payments are missed, the lender will take possession of the property (foreclose).
Auto loans are offered by banks, car dealerships and other sources to purchase a car. These are secured loans since the car is used as collateral. Auto loans typically span 36 to 72 months, although shorter and longer terms are sometimes available. Depending on your credit history, these loans may require a sizeable down payment and higher interest rates. Since the vehicle’s value will rapidly depreciate, often faster than the loan is paid off, you could owe more than the car is worth. As with a mortgage, the lender will repossess the car if enough payments are missed.
Student loans fund education-related expenses such as tuition, books, and living costs. They are unsecured, as no collateral is required. Student loans may range from 10 to 30 years, but unlike most other types of debt, these loans generally cannot be discharged through bankruptcy, resulting in a lifelong obligation. If you’re considering a student loan, remember that some degrees may not always result in higher-paying positions, making it difficult to justify the cost of the education relative to the income generated.
Credit cards are used for everyday purchases like utilities, groceries, clothing and entertainment, as well as more significant expenses like appliances, furniture, travel and emergency costs. No collateral is required, making them a form of unsecured loans. Credit cards are widely available from banks, financial institutions and retailers. As a form of easily accessible revolving credit, this debt can quickly accumulate. Credit cards typically come with relatively high interest rates. Since usually only a minimum payment is required, this can lead to prolonged repayment periods and more interest paid if the balance is carried over from month to month.
Personal loans are acquired for various purposes, such as home improvement, medical expenses and other personal needs. These loans are offered by banks, financial institutions and a variety of other lenders and may be unsecured or secured, depending on the lender’s requirements. Specific terms also vary by lender, but they typically require shorter repayment periods, which can lead to higher monthly payments.
A line of credit is a form of revolving credit (secured or unsecured) offered by banks, financial institutions and other lenders. The most commonly known is a home equity line of credit (HELOC). A HELOC allows you to borrow up to a certain percentage of your home’s equity (the difference between the current market value of your home and the amount you still owe on your mortgage). Your home is used as collateral. These loans are frequently used to cover large expenses like home renovations. A HELOC reduces the equity in your home, and depending on the housing market, you could end up owing more than your home is worth.
Payday loans are used to cover expenses until the following payday. They are offered at extremely high interest rates and fees. The short repayment periods (the next payday) can lead to a cycle of borrowing for struggling borrowers. Payday lenders are often known for their aggressive collection practices, adding to the stress of an already difficult situation. Financial experts do not recommend using payday loans and strongly encourage considering alternatives.
