There are many types of debt, some of which look better to lenders than others. But what’s good debt, bad debt or anything that falls between? Our in-depth guide explains the different types of debt so that you can make informed financial decisions.
What is Debt?
To put it simply, debt is when you borrow money with an agreement to pay it back. How you pay it back depends on said agreement. Sometimes you won’t need to pay anything for a few years, other times you’ll start monthly payments immediately.
Some of the most common types of debt you’ll likely have are
- Capital repayment mortgages
- Student loans
- Anything you buy with a credit card
- Car financing
Most debts fall into one of the four main categories:
Let’s look into these categories in more detail to help you understand what they involve and whether they’re a type of good debt or bad debt.
Good Debt Vs Bad Debt
Good debt is a type of borrowing that will improve your future and financial position. Good debt is planned and budgeted for, and most people have some at one point in their life.
Bad debt, on the other hand, can damage you financially and add little benefit to your life or financial stability. It can be hard to keep on top of your payments and you could face legal action or collections if you default or fall too far behind on your payments.
|Examples of Good Types of Debt||Examples of Bad Types of Debt|
|Student loans||High-interest credit cards|
|Short-term borrowing to build your credit score||Borrowing money to cover other debts|
The types of debt we’ll cover in this article are all classed as good types of debt, providing you budget accordingly and ensure you keep up with your payments. As with all types of debt, missing or late payments can lead to damaging your credit score or even facing having your home repossessed in the case of mortgages.
If your debt is secured, it means the loan is backed by some collateral, aka a specified asset the lender can take ownership of if you fail to make payments.
For example, a mortgage loan is secured by the property, meaning the lender could take ownership of the property if you fail to repay the loan. It effectively gives the lender reassurance that they won’t be left out of pocket if you fail to repay the loan for whatever reason.
From a lender’s perspective, it provides more financial security to opt for secured debt and it’s why there is often rigorous testing and checking before you can secure a loan. A lender will always check your income and outgoings and take your situation into consideration, such as how many dependents you have and your debt-to-income ratio for mortgage purposes.
Unsecured loans are one of the types of debt that don’t use any collateral as a backup. In other words, you don’t pledge any specific assets to secure the loan. It makes them riskier for lenders as they have no guaranteed way to recoup their investment should you fail to repay.
Due to this, your credit score has a bigger impact on your options and lenders will look at your credit reports to establish if they want to lend to you. As a general rule, people with the highest credit scores are offered better rates and bigger loans. In some cases, you may even find a credit card that offers cashback and other rewards.
Examples of unsecured debt include
- Personal loans
- Typical credit cards
- Student loans
In terms of what unsecured debt means for the borrower, you can expect to pay higher interest rates. This protects the lender against losses if you default on payments. Just because there’s no specified collateral at risk, you still face collections or a lawsuit if you fail to repay the loan.
Installment debt is when you pay your loan back in fixed instalments over a specified period of time. These types of debt can be secured or unsecured, depending on the agreement with the lender.
For example, car finance or mortgages are secured instalment loans. You agree on the amount to borrow and the timeframe you wish to pay it over, then pay it back via fixed amounts each month.
If you buy a sofa, even on a “buy now, pay later deal” it’s classed as an unsecured instalment loan because you haven’t specified any assets against the borrowing.
Instalment loans are one of the types of debt where your fixed payments cover the initial amount you borrowed plus the interest added on top. Depending on what you buy with the money, it can be viewed as good debt or bad debt, so spend wisely.
Revolving debt is one of the short-term types of debt mainly used by businesses. It’s like an open line of credit where you can borrow as much money as you need (up to your pre-agreed credit limit) and pay it back when you want to. The easiest way to think of it is like an open-ended loan, giving greater flexibility than many traditional types of debt.
For businesses especially, it’s a good debt management option to boost working capital that is going to be repaid quickly. You decide how much you want to borrow and repay each month, keeping the line of credit revolving.
Unlike traditional fixed business loans, you only pay interest on what you borrow for the time you borrow it. If you haven’t drawn down any money, you don’t pay interest.
Types of Debt: Your Options
If you’re looking to borrow money, the first step is to understand the different types of debt and whether you have the planning and budgeting to ensure good debt management.
Only when you fully understand the type of loan you’re looking at entering into should you proceed. If you have any doubts whatsoever, we recommend speaking to a professional who can advise you further.