What is debt?
Debt is a type of liability that happens when a person owes money to another person, organization, or institution.
Debt can be owed for any number of reasons, such as borrowing money from a bank to purchase something like a car or home, using credit cards to make purchases without having enough cash available to pay for them outright, taking out student loans for educational expenses, and not paying bills on time.
The debt owed is usually based on the total amount borrowed plus interest and fees accumulated over time. Paying off debt can take some time and requires financial discipline and responsible budgeting.
There are four main types of debt:
- Secured debts: This type of debt requires the borrower to put up some form of collateral in order to secure repayment. This means that if a borrower fails to make payments on their debt, the creditor can legally take possession of the asset used as collateral. Common examples of secured debts include car loans and home loans, which use a vehicle or home as collateral respectively.
- Unsecured debts: Unsecured debts are not backed by any form of collateral but still require payment according to the terms agreed upon between the two parties involved. Unsecured debts usually carry higher interest rates than secured debts as there is no security against defaulting on repayments, and creditors have fewer legal rights when it comes to collecting this type of debt.
- Revolving debts: These are the ones that allow customers to borrow money up to a specific limit, make payments over time, and then take the loan again. That’s where the “revolving” name comes from, meaning that once payments have been made on the debt, those funds become available for borrowing again. This type of debt requires regular minimum payments but allows more flexibility, and the clearest example of a revolving debt is the credit card.
- Mortgages: These are a type of secured debt specifically referring to properties. They involve taking out a loan that is secured against a property or real estate asset (collateral) owned by the borrower in order for them to purchase it outright or refinance existing debt already tied up in it. We separate mortgages from regular secured debts as they operate in a unique way, and represent the first source of debt in the United States, surpassing USD 11.67 trillion, according to the Federal Reserve Bank of New York.
While it’s easy to jump to the conclusion that any type of debt is bad, it’s important to understand that there’s a type of debt that can be beneficial in the long run (known as good debt) and another (bad debt) that can be riskier and more harmful to your financial situation overall.
What is Good Debt
Good debt is any type of loan or credit that ends up helping improve the borrower’s financial situation. Two great examples of good debt are mortgages and student loans since both offer long-term benefits by increasing their net worth in the future.
Home mortgages allow loan holders to purchase a property with low monthly payments while at the same time building equity in their home as real estate values rise over time.
Similarly, student loans often provide access to higher education or advanced degrees, which can lead to better job opportunities and increased earnings potential over the course of their life.
What is Bad Debt
Bad debt is any type of borrowing that does not add value to a borrower’s life or improve their financial situation in any direct way.
Credit card debt is an example of bad debt because it usually involves high-interest rates and fees that make it difficult for borrowers to pay off the balance quickly.
Other examples include car loans, as borrowers are not only paying high monthly payments with exorbitant interest rates but are buying an asset that quickly depreciates in value over time.
A debt that falls into the category of “bad” does not intrinsically mean that it shouldn’t be taken. If managed carefully and responsibly, there are also ways that bad debt can help borrowers achieve their financial goals.
The trick is in taking out loans that the borrower is comfortable putting up with and can pay on time consistently.
Disadvantages of missing debt payments
Good or bad debt, missing payments can have serious consequences; here are five disadvantages of overdue payments:
- Late Fees: Most creditors charge late fees for missed payments that can add up quickly over time, increasing the total amount a borrower owes and making it harder to pay off the balance in full.
- Lower Credit Score: Credit score takes into account how well a loan holder manages their debt. This includes making consistent, on-time payments. Missing or late payments will negatively affect a borrower’s credit score and make it more difficult to borrow money in the future when needed at reasonable interest rates.
- Collection Calls: If a loan holder misses several months of payments, creditors may start calling them as they try to collect what they are owed. This can be an incredibly stressful experience and will only get worse as long as payment continues to go unpaid or is delayed further down the line.
- Wage Garnishment: In some cases where debt remains unpaid, creditors may take legal action against individuals who do not pay their debts back in a timely manner by garnishing their wages through court orders. This means that a portion of the borrower’s future income from employment must go towards repaying the debt before any other expenses are covered like bills or groceries.
- Higher Interest Rates: Paying late could also result in higher interest being charged on top of existing loan balances, meaning more money needs to be paid out overall, which ultimately makes repayment more difficult than if payments had been made on time instead. This increased cost should always be taken into consideration when deciding whether or not it's best to wait longer before settling outstanding debts.
The amazing benefits of paying off debt
Paying off debt can be a difficult task to commit to, but its many benefits make it worth the effort. Here are our top 5:
- Lower Financial Stress: When an individual has outstanding debts they may experience increased stress levels due to worrying about how they will pay their creditors each month. Paying off debt can significantly reduce this worry and lead to improved mental health as a result.
- Improved Credit Score: A high credit score is essential for getting approved for loans or other financial products such as mortgages or car loans in the future. Paying off debt on time and in full will help build a positive credit history which will lead to a higher score over time.
- Savings & Investments: Paying off debt gives borrowers more freedom to focus on building wealth through savings or investments such as stocks and mutual funds. With no outstanding loans or credit weighing them down financially; they’re able to use the discretionary income for things like retirement planning or investing in real estate.
- Increased Opportunities: Having a good track record of paying back lenders on time is always beneficial when applying for new opportunities like jobs where having a good financial background plays an important role in decision-making processes. This also holds true when seeking out investment opportunities or taking out new loans, as you are seen as a responsible borrower.
- Financial Freedom: Paying off debt is one of the most effective ways to bring yourself closer to financial freedom. Taking steps to reduce or eliminate debt can help you become more financially secure and give you greater freedom in your life. Paying off debt can make it easier to save money, invest, and have more flexibility when it comes to your lifestyle choices.
Overdue Payments can be quite harmful to your financial situation, so it’s essential to avoid falling behind on your payments. Building strong financial habits and understanding how to properly manage your money can go a long way in helping you gain peace of mind and be debt-free as soon as possible. You’re not alone in your financial wellness journey. Join the Lever community today to help you reach financial independence!