What is debt and options for reducing it
Between credit cards, mortgages and auto loans, taking on debt is unavoidable for most of us. But when your amount of debt gets to be too much for you to handle, it may feel impossible to dig your way out of it.
There are a lot of ways to reduce or consolidate your debt, such as better budgeting and personal loans. The first step to gaining back control of your financial situation is to understand how debt works, how to chip away at it if you have too much and how to avoid it in the first place. We’re going to show you how to get a handle on debt. Don’t worry, you’ve got this.
Debt explained: What you need to know
When we talk about debt, we’re usually referring to the money we’ve borrowed that we haven’t paid back yet. The legal definition of debt isn’t limited to money alone, but in most cases — credit card balances, mortgages, student loans — debt is defined as money you owe to someone else.
Debt carries a pretty negative connotation — no one wants to be in debt, after all. But the truth is, taking on debt helps us pay for big-ticket items we otherwise couldn’t afford. The mortgage on your house? That’s debt. Your car loan? That’s debt too. As a financial tool, debt is so fundamentally woven into our everyday lives that it’s hard to imagine a world without it.
When your debt becomes too large, and your finances are stretched too thin to keep up with your payments, that’s when you land into trouble. Some debt is almost a necessity today, but there’s a thin line between the right amount of debt and becoming overwhelmed with your financial obligations.
4 most common types of debt
Not all debt is the same, and it’s important to understand the differences between different types of debt to avoid some sticky financial situations. These four types of debt, in particular, are the most common:
- Secured debt
- Unsecured debt
- Installment debt
- Revolving debt
1. Secured debt
This type of debt is backed by collateral. The most common example of secured debt is arguably a mortgage, because the lender has a stake of ownership interest in the property until the loan is paid off.
The upside to secured debt is that lenders may be more likely to extend a loan because there’s a concrete asset to retrieve if the borrower defaults. That also means there’s some degree of risk you take on as a borrower. In the case of a mortgage, you run the risk of the bank foreclosing on your home if you fail to keep up with your monthly payments.
2. Unsecured debt
In stark contrast to secured debt, there is no collateral involved with unsecured debt. Credit cards are the most notable example, but student loans, medical bills and personal loans could all qualify as well. That lack of collateral tips the level of risk more heavily toward the lender’s side. As such, loans that are considered unsecured debt may have less favorable financing terms attached to them. Just compare the interest rates on credit cards to current mortgage rates to get a sense of the gap between loan terms on secured and unsecured debt.
3. Installment debt
When you take out a loan for a set amount of money — say, to buy a house or a car — you create installment debt. You pay back this type of debt in set installments — hence the name — until it’s completely gone. It’s worth pointing out that these debt categories can overlap: A mortgage is an example of both secured debt and unsecured debt. Meanwhile, your credit card balance is considered both unsecured debt and revolving debt. Speaking of which …
4. Revolving debt
This type of debt typically refers to lines of credit like a HELOC mortgage or credit card. While you have a limit on how much you can borrow, the amount of the loan is open-ended and otherwise up to your discretion. Whereas installment debts are eliminated once they are paid in full, you can go back to the well as many times as you like with revolving debt as long as you make payments on what you owe.
How does debt impact your finances?
A big part of managing your finances involves balancing your debt. It’s normal to carry debt on car loans and mortgages, but excessive credit card charges could limit your financial flexibility. Debt also plays an important role in qualifying for a loan or opening up a new line of credit. Both the amount and type of debt you carry impact your credit score. Lenders will closely review your credit history to see how reliable you are paying back debt.
You may receive better loan terms like a lower interest rate if you have a track record of making payments on time and keeping your credit balances in check. On the other hand, a lower credit score could convince a lender to extend less favorable financing terms and maybe even reject your loan application entirely.
Depending on your financial situation, the type of debt you’ve taken on and the amount of debt you have, digging out of that hole can be very difficult. Credit card bills are one of the worst culprits, because the often-high interest rates add more debt to your balance each month. To regain control of your finances and boost your loan application prospects, you need to master your debt.
Popular approaches to paying off debt
There are a lot of different philosophies out there about the best way to get rid of debt. Often, these approaches tackle debt from a psychological perspective, rather than a purely financial one. Arguably the two most notable methods include:
Taking the snowball approach to paying off your debt focuses on winning smaller victories so you feel like you’re making progress no matter how incremental it is. The snowball method works like this:
- Order your debt from smallest to largest, ignoring interest rates or the long-term costs of those balances.
- While continuing to make minimum payments on all debts, focus on paying off your smallest balance first.
- Once that debt is gone, move on to the next account in line and make that your priority.
- Keep doing this until you’ve repaid all of your debt.
Scoring quick wins in this fashion rewards your efforts more frequently, especially from the outset. You’re more likely to stick with your repayment strategy if you feel like you’re seeing tangible results.
The avalanche method takes the reverse approach to this problem. You target your single biggest source of debt first — again, while continuing to make minimum payments — and pay it down before chipping away at smaller balances. The idea here is that once you get rid of your largest debt, the rest will fall into place easily. Both avalanche and snowball approaches have their supporters and are perfectly valid ways to pay down debt. It really comes down to what makes the most sense for you.
3 ways to reduce and avoid debt
Getting out of debt is tough, to say the least, which is why you want to avoid it in the first place. Now, there will always be some debt you need to take on — very few people have the cash on hand to buy a house without a mortgage, for instance. But generally speaking, you can follow these steps to keep your finances in check and avoid excessive amounts of debt:
- Create a budget
- Refinance your debt
- Consider a personal loan
1. Create a budget
Everyone should have a budget to help manage their money, save up for large purchases and keep enough left over for a rainy day. If you don’t have one, it’s really difficult to know exactly where your money is going and, as a result, overspend without realizing it. A budget helps you plan for every contingency and assign every dollar you make to a specific expense, whether it’s groceries, mortgage payments or going out for dinner.
Of course, once you still have to stick to that budget. That means putting off unnecessary purchases that you haven’t planned for or cutting back funds in one area to cover something else. It takes a lot of discipline to balance your own budget, but it’s worth it.
2. Refinance your debt
You may have debt refinancing options that allow you to change the terms of your loan agreement and reduce the total amount of money you owe lenders or creditors. Refinancing your mortgage, auto loans or credit cards could lower both your monthly payments and the long-term cost of your loans. If nothing else, it’s worth reaching out to creditors to see if they’re willing to refinance credit card debt and other outstanding balances.
3. Consolidate your debt
In some cases, taking out a personal loan to consolidate debt will help folks get a handle on their finances. A lender may give you a much lower interest rate on a personal loan compared with, say, a credit card account. You would also essentially be converting revolving debt into installment debt, which may be easier to manage and repay. Using another loan to pay off debt isn’t always the best course of action, so you need to carefully consider lending terms before deciding how you want to proceed.
Debt is a burden, but it’s often necessary if you want to pay for a house, car or higher education. That being said, debt can become a huge headache if you’re not mindful about your spending habits. Not only will excessive debt impact your finances, but it can also affect your prospects if you want to apply for a home loan.
Paying down debt can seem like an insurmountable obstacle, but anyone can do it with the right approach. Take your time to review all of your options and find the right method to repay and avoid debt. And don’t feel overwhelmed — anyone can dig their way out of debt.