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Understanding Debt to Avoid Financial Ruin
Debt occurs when you borrow money from a lender (like a bank) and agree to pay it back over time, typically with interest. Many Americans overspend or donât know how to budget their money, resulting in excessive debt. Debt can be a useful tool for achieving certain goals, but it can also cause stress and financial insecurity if it gets out of control. Emergencies (like natural disasters, medical problems, pandemics, or unanticipated job loss) can cause you to accumulate debt if you donât have money set aside for those times.
Not having an emergency fund is an emergency!
Not all debt is âbad!â If you stay on top of it, debt can be a great tool for your future. People take on debt to buy a home, invest in a rental property, go to school to kickstart their career, or start a business, all with the hopes of a return on the investment (like gaining equity in your home or profit from a business or rental property). In these cases, debt can be a positive investment. Itâs important to understand the loan terms and repayment so it will pay off for you.
Letâs dig into the different types of debt to gain a better understanding of how it all works.
Secured vs. Unsecured Debt
Secured debt is backed by collateral, like a mortgage or a car loan. If you default (stop paying) on the loan, the lender can repossess the collateral to recoup their losses. Secured loans often have low interest rates because the lender has a low risk of losing money.1 Unsecured debt isnât backed by collateral and includes credit cards, personal loans, and medical bills. If you donât repay the debt, the lender canât seize any of your assets to cover the outstanding balance. Since the lender takes on a high risk of loss, interest rates will typically be higher.
Source: OpenMoney
Revolving vs. Installment Debt
Revolving debt is like a credit card - itâs constantly available to you, and as long as youâre staying within your credit limit, you can continue to borrow up to that limit (so long as you pay it back). This can get out of control quickly if unmanaged! Installment debt is usually for large purchases, such as a house or car, and thus youâll have a set number of âdebt installmentsâ to pay back. The main takeaway is that revolving debt is easy to get carried away with - so when it comes to a credit card, you must keep your spending in check. Installment debt makes it easier to budget for because youâll always know what youâre paying (think about fixed expenses that are the same each time, like rent). Itâs good to know the difference between the two, but focusing sharply on revolving debt will keep your spending habits tight.
Source: Cash 1 Loans
Consumer vs. Business Debt
Consumer debt is for personal use; think credit cards, car loans, student loans, and mortgages. You pay back these loans back from your personal income, and your property could be taken if you donât pay (depending on your loan terms). Business debt is used by companies for business expenses, like purchasing inventory, equipment, or expanding. This can be a great investment if you can grow your business and increase profits!
The key difference is that business debt is repaid using your company's income, and the business is collateral. If you canât repay your business debt, you can lose your business. Unless you have your own business, you wonât have to worry about this, but it is still important to understand the basics.
Consequences of Excessive Debt
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