- 6 min read
- When you borrow money, you create debt.
- There are many types of debt, including secured debt like a mortgage or unsecured debt like a personal loan.
- Learn to use debt wisely, and have a plan to pay off your debt.
If you've ever borrowed money, you've taken on debt. Though debt can often be a useful tool in finance, it can also pose a significant hurdle if you take on too much or use it irresponsibly.
Don’t want to fall into that trap? Use this guide to learn more about the meaning of debt, how it works, when to use it, and how to pay it off when you do.
What is debt? Essentially, it’s money you borrow from another party. If you take out a mortgage to buy a house, that’s a debt. If you put those Amazon purchases on a credit card, that’s a debt too. If your friend loans you money to pay your rent, that’s also a kind of debt.
By definition, debt is something you are obligated to pay back. The terms of repayment vary depending on the type of debt and the creditor, but you’ll need to repay the borrowed funds nonetheless — and, often, with interest.
That’s the gist of debt’s meaning in layman’s terms. The actual legal debt definition, though, (according to U.S. Code), is “any obligation or alleged obligation of a consumer to pay money arising out of a transaction in which the money, property, insurance, or services which are the subject of the transaction are primarily for personal, family, or household purposes, whether or not such obligation has been reduced to judgment.”
Types of Debt
The above definition of debt is a broad one. For more insight into debt’s meaning, you need to look at the many types of debt that are out there and some examples of how each one works.
Secured debt means that your borrowed funds are tied to a piece of collateral — like a car or property. If you fail to repay your debt, the creditor can seize the collateral, sell it off, and use those funds to pay off the loan.
Generally speaking, qualifying is easier for secured financing because the collateral protects the lender in case of default. Secured loans may also come with lower interest rates and they often allow for longer repayment terms too. Examples of secured debts include car loans and home loans (mortgages, HELOCs, home equity loans, etc.).
Unsecured debts are not attached to any sort of collateral. Because of this, they’re typically harder to get (meaning they require higher credit scores), and they may have smaller borrowing limits and higher interest rates. Examples of unsecured debts include credit cards, student loans, and personal loans.
You could face debt collection efforts if you fail to repay an unsecured debt – “unsecured” does not mean you don’t have to repay the loan. Lenders sue creditors over unsecured accounts all the time.
The term “installment” refers to the way you’d repay such a loan – in regular installments until the balance is zero. Installment loans are very simple. The main components are the amount borrowed, interest rate, and term (number of years you have to repay), and those factors determine your monthly payment. An auto loan that you pay over five years is a good example of an installment loan.
Revolving debt is money you continue to borrow and repay at will. Rather than getting a lump sum, as with installment debt, you instead get access to a credit line from which you can withdraw money as needed. Examples of revolving debts include credit cards and home equity lines of credit (HELOCs).
Who Has Debt?
Debt is incredibly common in the U.S. In fact, according to a study by credit bureau Experian, the average American Gen Xer carries nearly $33,000 in revolving and installment debt. If you add in mortgage balances, it jumps to $292,000.
Here’s what debt totals look like for each generation as of 2021:
- Generation Z: $12,524 (revolving and installment debt), $192,276 (mortgage debt)
- Millennials: $28,317 (revolving and installment debt), $255,527 (mortgage debt)
- Generation X: $32,898 (revolving and installment debt), $259,100 (mortgage debt)
- Baby Boomers: $24,136 (revolving and installment debt), $198,203 (mortgage debt)
- Silent Generation: $11,725 (revolving and installment debt), $163,254 (mortgage debt)
According to the Federal Reserve Bank of New York, Americans carry nearly $16 trillion in total debt — more than $10 trillion of that in housing debt alone.
Pros and Cons of Debt
There are both good and bad sides to debt. On the one hand, it can be handy in emergencies. If a sudden expense, medical bill, or repair crops up, debt can be an easy way to cover the costs in the moment.
Debt can also allow you to purchase big-ticket items like cars, houses, and boats — items you likely couldn’t purchase outright with cash. You can then spread those costs out over time.
Finally, another advantage is that debt — when managed well and paid off on-time — can increase your credit score and open more financial doors down the line.
- Debt can help you cover sudden or emergency expenses.
- Debt allows you to purchase big-ticket items that wouldn’t otherwise be in reach.
- Debt can improve your financial options in the future.
The downside, though, is that you’ll usually pay interest to borrow the funds, which makes your credit purchase more inexpensive than a cash purchase. Debts can take a long time to pay off, and they can quickly get out of hand — particularly if you miss a payment.
There are risks, too. If you have secured debt, you might lose property and other assets if you fail to repay the balance. In other cases, you might face debt collection tactics or even need to file for bankruptcy.
- It usually comes with interest.
- You could lose property or face debt collection efforts if you fail to repay it.
- You could fall into a cycle of debt if it’s not properly managed.
When to Use Debt
In a perfect world, we'd all have enough money to pay for everything upfront and out of pocket. But sadly, that's just not the case for most consumers. Instead, many of us need to borrow funds to achieve our goals — to attend college or buy a house or car, for example.
While owing someone money isn’t ideal, debt can be a useful tool if you borrow with your means and understand the terms and repercussions of the arrangement.
Before taking on debt, you’ll want to make sure it’s:
- Necessary: Is the purchase unavoidable or an important goal of yours? Is there no way to pay for it in cash?
- Affordable: Can you comfortably afford the payments? Is the interest rate low? Will the loan stress your budget?
- Limited: Will you only use this debt for one purchase? Or might it tempt you to spend beyond your means?
If you have the money to avoid debt, it’s usually smart to do so. Just make sure you won’t drain your emergency fund by making a big-ticket purchase with cash.
Paying Off Debt
If you take on debt, stay on top of your payments and, when possible, put extra cash toward your balances. Windfalls like your tax refund can help here.
If your debts get out of hand or you’re having trouble making your monthly payments, you have options. You can:
- Contact your creditors: You may be able to renegotiate your terms, rate, or payment, which might make them more manageable. You may also be able to settle your debt for less than you owe.
- Talk to a credit counselor: Credit counselors can help you devise a holistic approach to tackling your debts. They can also put you on a debt management plan to streamline repayment.
- Consolidate your debts: Consolidation rolls your debts into a single loan, making it easier to manage and pay off. It can often reduce your interest rate too.
- Refinance your debts: If you have debts with higher interest rates, refinancing might help you get a lower rate (and subsequently, a lower payment). This is often a good option with car and mortgage loans.
- Reach out to a debt relief company: Debt relief companies can help with all facets of debt payoff. They will also work with your creditors directly and, often, reduce the total amount of debt you owe.
- File for bankruptcy: In extreme cases, you may want to consider filing for bankruptcy, as it can discharge many of your debts (meaning wipe them clean). Talk to a professional before filing, though. Bankruptcy comes with serious consequences and can stay on your credit report for up to 10 years.
Debt is often a part of life, particularly if you have goals of attending college, buying a home, or owning a car. If you have to take on debt, make sure you’re clear on the terms of the loan, as well as how it will impact your budget and long-term financials before moving forward. You should also consider talking to a financial advisor or credit counselor too. They can help you make the best decision for your finances.
Is debt always bad?
No, some kinds of debt are considered “good debt.” That’s because they help you accomplish financial goals. For instance, most people have to borrow money to buy their homes. If you had to save the entire purchase price, you might never buy a home – and according to the Harvard Center for Joint Housing Studies, home equity is the top source of wealth for families with moderate or low incomes. You might also take on “good debt” to start a business or get a degree that helps you earn more money.
What is “bad debt?” Bad debt is borrowing with long-term loans for short-term benefits. For example, taking on a five-year loan to finance a two-week vacation.
What determines my payment on a debt?
There are three components to a loan payment – the amount you borrow, the interest rate you pay, and the term (length) of your loan.
The longer your term, the lower your payment. However, taking longer to pay off your debt costs you more interest over the life of your loan.
Does consolidating debt make it go away?
No. Debt consolidation just means taking out a new loan to pay off several other loans. Usually, the new loan has a lower interest rate. That can help you pay off the debt faster. But when you consolidate debt, you are just restructuring it. You still owe the same amount.