Debt is generated whenever someone borrows money from another person. Depending on how much debt you take on and what you use it for, debt can either help or hinder your financial situation. Examine the mechanics of debt and the many types of debt in more detail.
Definition and Debt Examples
A person, corporation, organization, or government that owes money to another entity is said to be in debt. When you borrow money, you usually agree with the lender that you will pay back the money on a certain schedule, maybe with interest or a fee.
Credit cards, as well as loans for cars, students, and homes, are prominent forms of debt that most people are familiar with.
Bad debt versus good debt
Even though all debt has a cost, you can generally categorize any borrowed funds as either good debt or bad debt depending on how they affect your finances and your way of life. You can enhance your income or amass wealth by taking on good debt. Yet bad debt doesn't give many advantages or a return on your investment.
Mortgages and student loans are typical instances of good debt because they can boost your earning capacity and help you accumulate wealth.
Since they frequently have interest rates that are significantly higher than those on mortgages and student loans and may not yield a return on investment, credit cards and personal lines of credit are typically categorized as bad debt.
Depending on the terms, an auto loan could be considered good or bad debt: A loan with a high interest rate is probably a poor debt; but, the use (having a car to carry you to and from work is necessary) makes the loan a good debt.
Note
If the terms are unfavorable (for example, if they have high interest rates) or if the payments hinder you from investing or saving, even good debt can turn bad.
Why Does Debt Happen?
Individuals incur debt when they need (or desire) to buy something that is more expensive than they can afford to pay for out of pocket. Or, on occasion, people may decide to borrow money to pay for a specific purchase because they would rather use their cash for something else.
Only certain uses are permitted for some debt kinds. For instance, a mortgage loan is used to buy real estate, and a student loan is used to pay for educational costs. In the case of these kinds of debts, the party delivering the goods or services receives the funds instead of the borrower directly. For instance, the seller or the seller's bank receives the funds for mortgage loans.
Depending on their income and other expenses, each person has a maximum amount of debt they can manage.
A person (or organization, corporation, or government) who has accumulated excessive debt may need to file for bankruptcy in order to obtain legal relief from their debts.
The debtor may be relieved from some debts as a result of this judicial action. Once a person's debts have been discharged by the bankruptcy court, creditors can no longer demand payment.
Note
It could be helpful to speak with a consumer credit counselor before declaring bankruptcy so they can assist you analyse your debt-relief choices.
Types of debts
Unsecured debt and secured debt are the two general categories of consumer debt. You'll typically discover revolving debt and instalment debt inside those two categories.
Secured Debt
If you don't pay your loan as agreed, the lender has the authority to take particular collateral. Mortgage loans, auto loans, and secured credit cards are examples of common secured debts.
The lender has the authority to seize and sell the property if you fall behind on payments for a predetermined period of time and use the proceeds to pay off the loan. If the selling revenues are insufficient to pay off the remaining loan sum following this procedure, you can still owe money.
Unsecured debt
On the other hand, unsecured debt is unrelated to collateral and does not automatically grant creditors the ability to seize your property in the event that you default on the loan. Unsecured debt types include credit card debt, school loans, medical debt, and payday loans.
Note
Short-term loans like payday loans are very hazardous unsecured debts. The typical APR for a $300 payday loan is more than 300% in several jurisdictions.
If you don't pay an unsecured debt, creditors frequently sell delinquent debts to a third-party collection agency rather than seizing your property.
In order to collect payment, debt collectors may phone you, send you letters, or record the debt on your credit report. If such measures fail, the debt collector may sue you and request a wage garnishment order from the court.
**Instalment vs. Revolving Debt***
Revolving or instalment payments are the two main types of debt repayment. Recurring debt is not subject to a set repayment schedule. As long as you are paying the minimum amount due each month against any outstanding balance, you have access to a credit line. For instance, using a credit card is a typical method of accessing revolving debt.
In contrast, installment debt has a predetermined loan amount and a specified repayment period. A personal loan is an illustration of an installment loan: You repay it over a predetermined period of time, typically months or years, and your monthly payments are typically the same.
Key Points
When one party borrows money from another, debt is established.
A debt agreement enables the borrower to pay back loans over a predetermined time period, occasionally with a fee or interest.
When a borrower fails to make payments on a secured debt, the lender may be able to seize the asset.
Unsecured debts can be sold to a collection agency because they are not attached to an asset.
