Are you looking to borrow money?
Understanding the different types of debt, their unique aspects, and how good or bad they are for you is very important if you want to be seen as financially responsible.
In this guide, I’ll share some useful debt advice and also answer some FAQs to help you out.
What Really is Debt & How Bad Can It Be?
In simple terms, debt is the collective amount of money borrowed by one party from another. It is the amount of money a debtor owes to a lender.
If you borrow too much without repaying it, debts can lead to situations that seriously impact your credit rating and financial freedom, and even lead to court action against you. That’s precisely why you need good debt advice. You can get useful debt advice by looking it up online or by contacting an independent debt charity such as Payplan or StepChange.
Good Debt vs Bad Debt
Debts can be classified as either good debt or bad debt.
At the simplest level, if borrowed money increases your net worth and carries potential for future growth, you’re borrowing good debts. Conversely, if a debt decreases your net worth, is excessive, and you can’t afford it, it’s categorized as bad debt.
Examples of good debt include a mortgage, student loans, and essential items, while a bad debt may be clothes, appliances, vehicles, and other purchases that go down in value once bought.
Types of Debt
- Car Loans
Unlike a loan for a home, a car loan is a prime example of bad debt.
As an unwritten rule, it’s a bad idea to be accumulating debts for a new car, especially when you’re living paycheck-to-paycheck and don’t have streams of revenue to keep paying for the car in a crunch.
If the interest rate is low and you have the revenue to pay off your debts quickly, a car loan may be considered a good loan, but if you keep missing payments and the car’s value declines quickly, it’s a bad idea.
- Student Loans
If you’re investing in education for yourself, it’s financially classified as good debt.
It is empirically known that college graduates earn more than non-graduates, on average. Also, the interest rate on these loans is pretty low, which means they are pretty good debts.
Lastly, you only have to start repaying the loan once you graduate and you start earning more than a certain amount.
Education and a formal degree pay off in the long run, which means that if you’ve carefully analyzed all the details, borrow that student loan and don’t compromise on your education!
- Credit Card Debts
Not only are credit cards very confusing, they involve hidden costs and a ton of financial baggage.
If you use more than a certain amount of credit, your credit score suffers, which in turn leads to an untrustworthy image and more credit card debt.
What you’re getting with credit card debts simply isn’t worth it. It may allow you to splurge in the short-term, but believe me when I tell you, the interest on those debts will come back to haunt you.
- Unsecured Debt
What is unsecured debt? An unsecured debt is a debt without collateral, and is usually classified as bad debt.
What this means is that the lender lends money to the borrower based only on the borrower’s trustworthiness and a promise of repayment.
Unsecured debts may be right for you if you either don’t have expensive assets or are in a position where you can’t afford to put your assets up as collateral. However, do know that unsecured debts usually come with higher interest rates than secured debt.
- Secured Debt
Unlike unsecured debt, secured debt always involves some sort of collateral. Usually, that collateral or guarantee is an asset you own.
The reason why it involves collateral is pretty simple: it reduces the risk of lending. If the borrower puts up some asset of theirs, that means the lender doesn’t have to worry about receiving nothing if the borrower is unable to pay back their loan.
The amount of collateral varies, ranging from some small asset to even your home.
An overdraft is a mechanism that allows you to take more money out of your account than is available in it.
In essence, it allows you to borrow with interest from your bank when you don’t have the money you need in your account.
So when can an overdraft be useful?
For one, if you’re self-employed and need immediate cash at short-notice before you can process your payments, it can be massively helpful. Also, when you’re charged unexpectedly, you may want to agree to an overdraft and pay your bank back later.
Loans can be examples of good or bad debts, depending on both the financial situation of the borrower and the reason for borrowing the money. Loans have various subtypes, such as a home equity loan.
For instance, a loan may be a great idea for someone with an amazing credit score, but not so much so for someone with a poor credit rating, as they will likely face a very high interest rate.
FAQs – Debt Types & Getting Out of Debt
How much should I borrow?
Here’s some debt advice: this depends on your living expenses, base income, assets, how much you already owe, your credit rating, and a few other things.
Use this formula for help:
Gross income – tax – existing commitments – new commitments – living expenses – buffer = monthly surplus.
What are the 4 types of credit?
The four types of credit are as follows:
1). Revolving credit, which allows you to borrow money up to a specified limit.
2). Charge cards, which resemble credit cards but unlike them, must be paid for each month.
3). Installment credit, which specifies a borrowed amount, a regular monthly payment, and the period of payment.
4). Service credit, which allows you to pay for a service at a later date.
Who are debt collectors and what can they do?
Debt collectors are individuals that your creditor can pay to collect debt from you. Usually, they charge a part of the debt you owe as their fee.
Can you go to prison because of debt?
Yes, you can go to prison if your creditor decides to press charges when you’re not paying. However, you do have several options to avoid this, such as bankruptcy or a Debt Management Plan (DMP).
A Quick Recap
I understand how frustrating it can be to find yourself in a situation where you can’t pay back your loan or when you need to take a loan but are unsure of whether it’s a good or bad choice.
I’ve tried to cover all about debt you need to know and discussed both good and bad debt.
If you need more debt advice, do reach out to us!