But understanding the types of debt can help you avoid financial predicaments.
There’s secured debt. There’s unsecured debt. There’s revolving debt and installment debt. The average American has about $90,000 worth of debt across these categories.1 When you understand the differences between them, you can be more confident in your money moves—and when taking on debt may be right for you. Let’s take a look.
Secured debt is backed by collateral—that is, backed by an asset that you own (or a co-borrower owns). Auto loans and home mortgage loans are a good example. If you default on your payment, the lender can repossess your car or your house. All else equal, a secured loan is lower risk to the lender, which means a secured loan will likely have a lower interest rate than an unsecured loan.
Unsecured debt is not backed by collateral. Credit cards are a good example. Lenders of unsecured debt, including credit card issuers, rely on your good faith and ability to repay the loan. The average American has just over $6,000 in credit card debt, and if we didn’t pay those bills the credit card issuers could go to court to reclaim any money owed.2 All else equal, an unsecured loan is higher risk to the lender, which means an unsecured loan will likely have a higher interest rate than a secured loan.
Revolving debt is debt you have access to, up to a maximum amount, on a recurring basis. Once again, credit cards are a good example. Credit cards obligate you to pay a minimum monthly amount on your balance. If you stay under your credit limit, you’re able to continue borrowing in flexible amounts. This type of debt choice continues to grow in popularity, as more and more people buy goods and necessities on credit.3
Installment debt is non-revolving debt where you borrow a fixed amount of money and repay in fixed amounts over a set period of time. Auto loans, home mortgages, and student loans are good examples of installment debt. The payment you make each month is known as an installment.
When to borrow what
As we’ve seen, each type of loan is suited for different scenarios.
For example, there may be situations where you’re able to choose between a revolving loan (e.g., a credit card) and an installment loan. Revolving loans are useful when you need flexibility in the amount you borrow (and/or the amount is small), and flexibility in the time allotted to pay back the loan.
Likewise, there may be moments when you choose between a secured loan vs. an unsecured loan. For example, you may wish to take out a personal loan to make a home improvement. If you have assets you are willing to offer as collateral (i.e., to “secure” the loan) you may be able to receive a lower rate.
Knowledge is confidence
Debt can be a scary topic. But understanding how debt works will alleviate anxiety around the unknown and empower you to make better decisions.
Don’t worry, you got this.