Anytime someone borrows money from someone else, debt is created. Debt can either help or hurt your financial life, depending on how much debt you take on and what you use it for. Learn how debt works, and dig deeper into the different types of debts.
Definition and Examples of Debt
Debt is money that one entity—a person, business, organization, or government—owes another entity. When you borrow money, you’ll typically make an agreement with the lender that you’ll repay the money on a schedule, sometimes with interest or a fee. Most people are familiar with common types of debt like credit cards and auto, student, and home loans.
Good Debt vs. Bad Debt
While all debt comes with a cost, you can generally classify any borrowed money as either good debt or bad debt based on how it affects your finances and your life. Good debt helps you increase your income or build wealth. Bad debt, however, doesn’t provide many benefits or offer a return on what you pay for it.
Student loans and mortgages are common examples of good debt because they can help you increase your earning potential and build wealth.
Credit cards and personal lines of credit are generally classified as bad debt since they may not provide a return on investment and often come with interest rates that are much higher than those on mortgages and student loans.
An auto loan could be good or bad debt depending on the terms: A high-interest-rate loan is likely a bad debt; the use (a car that gets you to and from your job is essential) makes the loan good debt.
Even good debt can become bad debt if the terms are not favorable (e.g., high interest rates) or if the payments prevent you from saving or investing.
How Does Debt Work?
People take on debt because they need (or want) to purchase something that costs more than they can pay in cash. Or, in some instances, people may want to use their cash for something else, so they borrow money to cover a particular purchase.
Some types of debt may only be used for specific purposes. For example, a mortgage loan is used to purchase property, and a student loan covers education expenses. For these types of debts, the borrower does not receive the money directly; the funds go to the person or organization providing the goods or services. With mortgage loans, for example, the seller or the seller's bank receives the money.
Each person can only handle a certain amount of debt based on their income and other expenses. When a person (or organization, business, or government) has become overly indebted, they may need to seek legal relief of their debts through bankruptcy. This legal proceeding allows the debtor to be released from certain debts. Once the bankruptcy court discharges someone’s debts, creditors can no longer require payment.
Before filing bankruptcy, it may be beneficial to talk to a consumer credit counselor who can help you weigh your debt-relief options.
Types of Debt
Consumer debt can generally be categorized as secured debt and unsecured debt. Within those two categories, you’ll usually find revolving debt and installment debt.
Secured debt gives the lender the right to seize specific collateral if you default on the agreement. Common secured debts include mortgage loans, auto loans, and secured credit cards.
After you're delinquent on payments for a certain amount of time, the lender has the right to take possession of the property and sell it to repay the loan. You can still owe money after this process if the proceeds from the sale aren't enough to cover the outstanding loan balance.
Unsecured debt, on the other hand, is not connected to collateral and doesn't automatically give creditors the right to take your property if you default on the loan. Examples of unsecured debt include unsecured credit cards, student loans, medical bills, and payday loans.
Payday loans, a type of short-term loan, are an extremely risky unsecured debt. In many states, the average APR for a $300 payday loan is more than 300%.
Instead of taking your property if you don’t repay an unsecured debt, creditors will often sell delinquent debts to a third-party collection agency. Debt collectors use a variety of tactics for getting payment including calling you, sending letters, and adding the debt to your credit report. If those efforts are unsuccessful, the collector may sue you and ask the court for permission to garnish your wages.
Revolving vs. Installment Debt
Debt repayment usually comes in two forms: revolving or installment. Revolving debt doesn't have to be repaid on a fixed schedule. You have access to a credit line as long as you're making minimum monthly payments toward any outstanding balance. For example, a credit card is a common way to access revolving debt.
Installment debt, on the other hand, has a fixed loan amount and a fixed repayment schedule. One example of an installment loan is a personal loan: You pay it back over a certain number of months or years, and your payments are usually the same every month.
- Debt is created when one party borrows money from another party.
- A debt agreement allows the borrower to repay borrowed money over a certain period of time, sometimes with a fee or interest.
- Secured debts allow lenders to claim an asset if the borrower defaults on the debt agreement.
- Unsecured debts are not tied to an asset and may be sold to a debt collection agency.