Debt is money you owe to an individual or institution. People and corporations alike use debt for a wide range of expenses. When you take on debt, you will have to pay back the principal amount (the amount you borrowed) along with interest and fees.
Repayment arrangements will be a part of a loan contract or agreement that both parties must follow. Below you will find some more information on debt agreements, types of debts, and how debt will impact your overall finances.
How Does Debt Repayment work?
How you repay your debt or loan will depend on your lender and the loan contract. Your loan contract will include details like the minimum amount due for each payment and the amount of interest you are being charged overall. It will also have the duration of the repayment period and conditions to follow (along with the penalties if violated).
For most debts, you can make online payments or transfer the funds electronically. In some cases, you may also be able to mail a check or make your debt payments in person.
“Good” Debt vs. “Bad” Debt
There are several kinds of debt you can take on. Although all of them will mean repayment, some can have a lasting positive impact on your financial situation while others may not. Any debt that adds to your net worth or you take out to make money or create financial security is “good” debt. Here are debts that are considered good debt and are a few ways to make your money work for you:
- Mortgages or Home Loans
- Business Loans
- Student loans
- Investment Loans
- Debt Consolidation Loans
- Personal loans for essentials
“Bad” debt can be considered any loan that is just for consumption rather than personal and financial growth. These types of loans are usually used for purchasing things that depreciate in value over time. Using credit cards for shopping or loans for car purchases are a couple examples of bad debt.
Secured vs. Unsecured Debt
Secured debt will involve an asset that acts as collateral for the lender, while an unsecured debt does not. There are a few reasons why collateral may need to be involved in a loan process. Usually, it’s because the borrower doesn’t have a good credit score or meet the minimum income requirement. To qualify for unsecured debts, you will likely need good credit. Or some borrowers turn to unsecured bad credit loans for quick funding.
The Importance of Interest Rates
Interest rates are generally the most expensive part of borrowing. So it is essential to understand the different kinds of interest rates that can be a part of a loan. Getting reasonable interest rates will depend on the loan type, the lender, and credit history. Before choosing a loan, look at several loan types and lenders to compare loan terms.
How Much Debt Should I Have?
Most Americans have several types of debt; credit cards, student loans, auto loans, or mortgages are just a few examples. Having different debts is an integral part of diversifying your financial portfolio. It can help you establish a credit history. However, how much debt is too much debt?
One way to look at this is through your budget. If you cannot take care of essentials and save while repaying your debts, you may have too much debt. When looking at it as a percentage of your income, 35% or less is recommended to be your debt-to-income ratio or DTI. You will notice that the amount of debt will impact eligibility when applying for loans and will have an impact on your credit score.
How Debt Will Impact Your Credit Score?
As mentioned briefly above, the number of debts you have will impact your credit score. Each time you take out a loan, it will be reported to all three major credit bureaus and go on your credit report. If your debt-to-income ratio goes above the recommended 35%, you can lose a few points on your credit score.
Additionally, how you handle your debts will also impact your credit score. For example, having a loan for a few years and making on-time payments can help build or improve a score, while the opposite is true if you miss any payments. Learn more about your credit score algorithm to better understand how applying for and repaying a debt impacts your score.
Strategies for Debt Repayment
There are several ways to go about debt repayment. Here are a few strategies that people commonly use:
- Pay off high-interest debts first — high-interest rate debts can take the longest to pay off. And so, one strategy is to pay them off first—also known as the “debt avalanche.”
- Debt consolidation — This process involves using a 0% interest loan or low-interest loan to pay off all other existing debt. Debt consolidation aims to get a lower interest rate and only have one payment due each month. Online bill presentment can also allows people to pay multiple lenders and bills in a structured format that easily fits their budget.
- Pay more than the minimum monthly payment — another strategy that can work for debt repayment is to pay more than the minimum balance due. Even a little more each month can help make repayment much faster, and in some cases, help you save on interest.
Debt is borrowed money that you need to repay, usually with interest. Knowing the different kinds of debts that exist and how they will impact your finances is an essential part of being an informed borrower.