Types of Debt
Debt is often described in negative terms. But borrowing money, or ‘taking on debt’, isn’t necessarily a bad thing. Manageable debts, that you can comfortably pay back over an agreed period, are often necessary in order to take that next step in life. It’s only when debt repayments become unmanageable or unaffordable that debt becomes a problem. There are many ways debts can suddenly become unmanageable, for example:
- Unemployment or underemployment
- Illness leading to loss of work
- Unexpected new costs such as essential home repairs
Types of debt
Debt comes in many forms such as loans, credit cards, store cards and outstanding tax payments, but it can generally be split into two main categories; secured debt and unsecured debt.
Secured debts are taken out against an asset. For example, when you take on a mortgage the bank secures that debt against your home. If you can’t pay your mortgage, your bank may repossess your home to recover the debt. The same goes with a secured car loan. Debts that require a guarantor are sometimes classified as secured too, because the lender can go to the guarantor for payment if you’re unable to service the debt but the lender does not have any security against any of your assets.
Unsecured debts, such as credit card debt, are not taken out against an asset or covered by a guarantor. If you can’t pay back the debt, the creditor can’t attempt a repossession, but failing to make repayments may still damage your credit score and lead to other problems.
Difference between manageable and unmanageable debt?
Nobody willingly takes on a debt knowing they can’t pay it back. But circumstances change, and a debt that was once manageable can suddenly become unmanageable. When borrowing money, look at the whole picture. Debts that look manageable at first glance may actually be harder to pay back than you think. Important things to consider when borrowing money:
- Interest rate – This may vary according to your personal circumstances, the amount you borrow, the lender’s own criteria and whether the debt is secured or unsecured. A debt with a higher interest rate will cost more and may take longer to pay back. Can you afford to pay back the capital AND the interest?
- Repayment amount – This is the amount of money you agree to pay back to clear the debt, typically on a monthly basis. If the repayment amount is likely to stretch your budget, you may struggle to service the debt.
- Repayment term – This is the length of time you agree to make repayments. Typically, a debt with a longer repayment term has a lower monthly repayment amount when compared to borrowing the same amount over a shorter term. This may make the debt more manageable, but it also means you may end up paying more money back over the lifetime of the debt.
- Penalties for late payment – Some lenders are stricter than others. Look out for high late payment penalties as these can cause your debt to grow quickly if you’re struggling to make repayments.
Prioritising your debt
If you’re struggling to pay back multiple debts, it’s really important to prioritise.
We suggest that if possible, pay your most important debts first. It’s normally useful to prioritise secured debts. If all of your debt is unsecured, think about which debts will cost you the most if you miss repayments.