What is Debt?

If you’ve ever borrowed money or used a credit card to cover a car repair, you’ve created debt. Debt is money you borrow to help pay for something you can’t afford right away and agree to pay back over time, usually with interest. Debt can help you buy important things like a home or everyday needs like groceries and gas when money is tight. But if you don’t manage it well, debt can make it harder to get loans or credit in the future and may put a strain on your budget.

Knowing how debt works — and the responsibility that comes with it — can help you make smart money choices. Let’s go over different types of debt and how to handle it wisely so you can stay on top of your finances and reach your goals.

What is debt?

According to the Consumer Financial Protection Bureau (CFPB), the definition of debt is “an amount of money that a person or institution has borrowed and is expected to repay, usually with interest.”

Debt that a person owes (instead of a business or government owing it) is called “consumer debt” or “personal debt.” Consumer debt is often used to cover unexpected emergencies like a root canal, or to make major purchases like a new car a little more manageable. Even using a credit card for convenience or to make ends meet between paychecks is a type of consumer debt.

How does debt work?

Every time you borrow money –– even from a friend or family member –– you owe a debt. Banks, credit unions, brick-and-mortar and online lenders usually have specific requirements for lending money when you apply for a loan or line of credit. Since lenders can’t be certain if a borrower will repay their debt, they typically rely on an applicant’s credit history and financial information to make informed decisions. Those informed decisions determine your eligibility, loan amount or credit limit and interest rate.

Each loan or credit card comes with an interest rate, which is the cost of borrowing money. It’s a set percentage charged by the lender that is applied to the full amount you borrow. Over time, this percentage determines how much extra you’ll pay in addition to repaying the original borrowed amount. A high interest rate means you’ll pay more over the course of a loan than you would with a lower interest rate.

Each lender may prioritize different aspects of your financial background to decide whether or not to approve your application, what type of loan you qualify for, its interest rate and how much money to lend to you. At OneMain, we work with a wide range of credit scores and consider your whole financial picture to help you find a loan that’s right for you.

If you meet the lender’s requirements, they will offer you a loan. Before you can receive funds, you must agree to repay the debt according to a specific set of terms. Let’s break it down further.

Types of debt

Lenders may offer many types of loans, credit cards and other ways of extending credit. Consumer debt falls into one of two categories: installment debt or revolving debt.

Installment debt

When you take on installment debt, you borrow a fixed lump sum of money, called the principal. You are charged interest on that principal, and the interest is applied to the balance of your loan. You then pay off the principal and interest in regular installments until the loan balance is zero.

Installment debt works best when you know exactly how much money you need. Some of the more common uses for installment debt are personal loans, home, auto or student loans. Personal loans can be used for a wide range of expenses. For example, if you’re moving into a new home, you may want to look into a moving loan, which is a personal loan that can cover expenses like a rental truck or movers.

Revolving debt

Revolving debt is a line of credit that you can borrow from as needed, up to your approved credit limit. As you repay your balance and any interest on it, the amount of available credit you can use is replenished. If you consistently make on-time payments, your lender may decide to increase your credit limit. Types of revolving credit include credit cards, charge cards and lines of credit.

To give you a better idea of how revolving debt works, let’s look at an example of how a credit card is typically used. Suppose a card issuer offers you a credit card with a $1,000 limit. You can swipe your card for $100 worth of groceries, a $7 latte and a $50 pair of shoes in one weekend and still have $843 available to spend on your card. If you have an outstanding balance –– the part of the balance you didn't pay on the payment due date –– from billing cycle to billing cycle/month to month, then you are paying interest. If you pay the $157 in full, there is no interest. You don’t necessarily have to repay your entire balance every month. Lenders usually set a minimum monthly payment based on a percentage of your balance. However, paying down as much of your balance as possible can help you save money on interest and protect your credit score.

Secured vs. unsecured debt

Installment and revolving debt may be either secured or unsecured. A secured loan requires you to provide collateral, such as your car or other valuable item. With a secured loan, the lender could take possession of the collateral if you were to default on the loan. However, secured loans often come with lower interest rates and annual percentage rates (APRs) than unsecured loans — and you may be able to borrow a larger amount, too.

Once a lender approves your application and you agree to take the loan, they place what’s called a “lien” on the collateral you’ve used to secure the loan. A lien gives the lender the right to claim the property used as collateral if the borrower doesn’t repay the loan. Take a car, for example. The lien designates the lender as the company that you owe money to for that car. A lien, then, makes it difficult for you to sell the car until your loan is paid off. And if you fail to make timely payments, the lender has the right to take possession of your car, sell it and use that money to pay off your outstanding debt.

Unsecured loans don’t require collateral, but to qualify for this type of loan, you may need a higher credit score and lower total debt. A secured loan could be a good option if you have less-than-perfect credit. Collateral may also open the door to favorable rates and higher loan amounts.

Pros and cons of debt

Debt can help you access the funds you need or ease financial stress. However, mismanaging debt can bring on harmful consequences. Understanding the advantages and disadvantages of debt could help you make smart money decisions and stay on top of your credit score.

Pros of debt

• Debt can help you achieve goals like continuing your education or buying a home.
• Well-managed debt can help build your credit score, if you’re careful to make on-time payments and keep your credit utilization low.
• Debt can help you handle unexpected household emergencies or expenses like car repairs, funeral costs or medical bills.
• Installment debt can help you make big purchases by allowing you to break payments down into manageable monthly increments instead of paying one large sum at once.

Cons of debt

• Missed payments or high balances could lower your credit score and make it harder for you to qualify for loans and credit cards in the future.
• High-interest debt costs you more money than lower-cost debt or paying with cash in both the short and long term.
• Unmanageable debt can trigger emotional stress for individuals, couples and families that spills over into other parts of your life.
• Changes or dips in income or new higher expenses could make managing payments overwhelming – even if they weren’t before.

How to manage debt

Managing debt starts with knowing how much you can afford to borrow and having a plan to pay it back. If you take on too much debt, keeping up with payments can be tough and may cause financial stress. Here’s how to figure out what you can handle and how to pay it off.

Step 1: Know what you can afford

Before borrowing money or using credit, take a look at your income and expenses. Ask yourself:

• How much do I spend each month on housing, food and other essentials?
• How much do I already owe on credit cards or loans?
• Can I afford another monthly payment without struggling to pay my other bills?

A common guideline is to keep total debt payments below 36% of your monthly income. This helps you manage debt without it taking over your budget.¹

Step 2: Create a plan to pay off debt

If you already have some debt and are concerned about it being unmanageable, making a plan to pay it off can help you stay on track. Start by listing everything you owe, including the balances, interest rates and minimum payment. Then choose a repayment strategy:

Debt snowball method

The debt snowball method prioritizes the smallest debts first. For this approach, you put as much money as you can toward your smallest debt and continue making minimum payments to the rest. When you repay the smallest debt, put the funds you’ve freed up toward the next smallest debt, and so on.

With this tactic, you could make progress quickly and improve your financial confidence. After all, paying off a whole credit card balance or loan is a major accomplishment. However, you may pay more interest using this approach than you would with a different approach.

The debt avalanche method

The debt avalanche method is a similar method to the snowball method. The primary difference is that instead of prioritizing the smallest debt, the avalanche method focuses first on the balance with the highest interest rates. After you’ve repaid your highest-interest debt, you can move on to the one with the next highest interest rate. This technique saves you money in interest, but you may not see results right away.

Debt consolidation

If you’re juggling multiple credit cards or loans and having a hard time keeping track of bills, don’t panic. A [debt consolidation loan](https://www.onemainfinancial.com/personal-loans/debt-consolidation) may help you get back on track. Debt consolidation is when you take out one personal loan and use its proceeds to pay off multiple debts, leaving you with just one payment to make every month. The new loan pays off the old balances. That way, instead of worrying about multiple due dates and interest rates, you can make one payment a month to just one lender.

Ideally, a debt consolidation loan should make your payments more manageable and relieve stress. At OneMain, we work with you one-on-one to understand your needs and help you decide if a debt consolidation loan fits your budget.

When managed responsibly, debt can be a helpful tool

Sometimes, debt gets a bad rap. But the fact is, debt is a part of life for most people. What matters most is how you handle it. Debt could make it possible for you to buy a new car or plan a long-awaited family vacation, but it’s important to have a repayment plan before you take on extra debt. A thoughtful approach to borrowing money could help you achieve your goals and stay on track for a bright future.

Sources:

1. https://www.bankrate.com/real-estate/what-is-the-28-36-rule/