Types of Debt and What Sets Them Apart

Two debts with the same balance can behave in completely different ways. One can cost you your car if you fall behind; another can be paused when you lose your job; a third keeps growing because it has no end date. Before choosing what to pay first, it helps to know what kind of debt each one is. This chapter sorts debt along the lines that matter most for cost and risk, then explains which bills come first when money is short and how debt shows up in your credit file.

Secured and unsecured debt

Secured debt is backed by something the lender can take if you stop paying. A mortgage is secured by the home and a car loan by the car. Because the lender can recover part of its money by repossessing or foreclosing, secured loans usually carry lower interest rates. The trade-off is that falling behind can cost you the asset itself, along with whatever you have already paid into it.

Unsecured debt has no collateral. Credit cards, most personal loans, medical bills and most student loans are unsecured. The lender relies on your promise and your credit record, so the rate is higher. If you stop paying, the lender cannot simply take your property; it has to report the missed payments, send the account to collections and, in some cases, sue for a court judgment before it can garnish wages or freeze a bank account.

The difference in rate is easy to see on the same amount over the same term.

At 7.0% the payment is $396 a month and the total interest is $3,761. At 14.0% the payment is $465 and the interest is $7,922. The rates here are illustrations; your own depend on your credit and the lender, but the pattern holds: the lender charges for the risk it carries.

Revolving and installment debt

Installment debt is a fixed sum borrowed once and repaid on a schedule: mortgages, car loans, personal loans and most student loans. Each payment covers that month's interest and some principal, and the loan ends on a known date. The structure is its strength. You cannot fall further behind by paying as agreed.

Revolving debt is a credit line you can draw on again as you repay it, such as a credit card or a home equity line of credit. There is no end date. The required minimum payment on a card is set low, often little more than the month's interest plus a small slice of the balance, so a balance can last for many years. Revolving debt also tends to carry the highest rates. The Federal Reserve's G.19 release reports the average rate on cards that are charged interest, and it has run far above the rates on car loans and mortgages for years.

Because revolving debt has no built-in finish line, the most useful thing you can do with it is give it one: decide on a fixed payment that clears it by a date you choose. Chapter 3 shows how much that decision changes the cost.

Federal and private student loans

Student loans look alike on a statement, but federal and private loans are different products.

Federal student loans are made by the U.S. Department of Education. Their rates are set by law for each school year and are fixed for the life of the loan. They come with protections no private lender is required to offer: repayment plans tied to income, deferment and forbearance in hardship, discharge on death or total and permanent disability, and forgiveness programs such as Public Service Loan Forgiveness. The government can also collect in ways other lenders cannot, including taking tax refunds and garnishing wages without a court order once a loan is in default.

Private student loans come from banks, credit unions and online lenders. Rates can be fixed or variable and depend on credit. Repayment terms and hardship options are whatever the contract says. Refinancing a federal loan into a private one may lower the rate, but it permanently gives up the federal protections. Chapter 8 and the student loan book on this shelf cover the choices in detail.

Which bills come first when money is short

When there is not enough to pay everything, interest rate is not the only thing that matters. The consequences of not paying differ widely, and some can make the rest of the problem worse. A common order of priority, in line with the guidance of nonprofit credit counselors, looks like this:

1. Housing and utilities. Rent or mortgage, heat, power and water keep you housed and able to work. Falling behind on a mortgage can start a foreclosure; on rent, an eviction.
2. Transportation you need to earn income. A car loan or lease, plus insurance, if losing the car means losing the job.
3. Debts with legal power behind them. Child support, and federal and state taxes. Tax agencies can place liens and take wages or refunds without the court case a private lender would need.
4. Federal student loans. If you cannot pay, switch to a plan based on income or ask for a pause rather than simply stopping; default triggers collection powers and fees.
5. Unsecured debts. Credit cards, personal loans and medical bills. Missing these damages your credit and leads to collections, but no one can take your home or car over them without first going to court.

This order is about protecting essentials during a crisis, not about where extra money should go in normal times. When you can pay every minimum, extra payments are usually best aimed at the highest rate, as chapter 5 explains. And when you know you will miss payments, contacting lenders early, the subject of chapter 7, often opens options that disappear once an account is in collections.

How debt shows up in your credit file

Every loan and card you have is reported to the three nationwide credit bureaus, and your credit scores are calculated from those reports. The details of the scoring models are proprietary, but the main factors are public: whether you pay on time, how much you owe relative to your limits (your credit utilization), how long you have had credit, the mix of accounts and how often you apply for new credit. Payment history and amounts owed carry the most weight.

Two consequences matter for anyone paying down debt. A payment 30 or more days late can be reported and generally stays on your report for up to seven years, so automating minimums protects your score as much as your budget. And paying down card balances lowers utilization, which can lift a score within a month or two. Federal law lets you see your reports from each bureau for free; the Federal Trade Commission's free credit reports page explains how. Check them for accounts you do not recognise and balances that are wrong, and dispute errors with the bureau that reports them.