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Here at Debt.com, debt is the whole reason we exist. It can be a confusing and challenging concept to understand, so this guide will walk you through the basics of debt, what it means, the different types of debt, what causes debt, and how you can start to get out of debt for good.

Definition of Debt

Debt is generally defined as something owed to another. Debt used as a noun is really a form of money. It’s money owed that you are responsible for. You will pay this money back sometime in the future.

When a person wants to purchase goods or services but doesn’t have the money right then and there, they borrow it from a bank or lending institution and agree to pay that money back within a fixed or flexible period of time. Most people will borrow money from a bank or lending institution but sometimes, they may borrow the money directly from the merchant who is selling the product.

Because someone is lending you the money, you are usually obligated to pay that money back with interest as a fee for using their money. That’s how lenders turn a profit.

Types of Debt

There are many different kinds of debt that affect your credit and your financial life in many different ways. First, learn the difference between secured and unsecured debt, plus revolving and installment payments. Then find out if your debt is good or bad.

Secured Debt

You have secured debt when you borrow money after you gave collateral as a guarantee in order to get the loan.  Secured debts are usually loans that are made for automobiles, homes, boats, furniture or other types of “real property.”  When you are unable to make the payments on a loan that is secured, the lender may repossess or foreclose on that property to recoup the balance of the loan.

Unsecured Debt

Unsecured debts are loans that do not require any type of collateral to help protect the lender’s investment on the money that they lent you. Most credit cards are unsecured,  as well as charge cards, student loans, and personal loans. If you do not make the payments on unsecured debt, there is nothing that you gave the lender to guarantee the loan that they can take. However, they have a right to sue you in civil court to try and force repayment through things like wage garnishment.

Revolving Payments

Credit cards are a good example of debt that requires revolving payments. Put simply, revolving payments happen when a creditor extends a line of credit to you. You follow your credit contract and make payments, which aren’t a fixed amount. With credit cards, the only amount you are required to pay every month is the minimum payment. If you only pay the minimum, you carry a balance which is charged interest.

Installment Payments

Installment payments are required when a lender gives you a set amount of money that you have to repay by a certain date. You make periodic fixed payments over this term until you have fully paid what you borrowed plus any fees or interest.

Is Your Debt Bad or Good?

That’s right – not all debt is bad. In fact, there are some types of debt that are great to have in your financial portfolio. Start by learning the difference so you know where you stand.

Bad Debt

Without really understanding the basics of credit and fully understanding what you are committing to, debt can get out of control pretty quickly. Credit is not “extra” money. When you start using credit as an extension to your paycheck, it’s easy to end up in trouble. This is when credit gets bad. Bad debt is defined as any debt that does not give you something of tangible value that increases your net worth over time.

Credit Card Debt

When you don’t pay off everything you charged on your credit card and only pay the minimum required payment, you carry a balance that starts getting charged interest. This builds up and get can get hard to handle.

Often, people will charge $500, $1,000 or more on their credit cards, knowing that they don’t have the regular monthly income to pay for the charges. They are only thinking about the minimum payment that they will have to make each month. When this continues, they will reach their spending limits on those cards. Although they tell themselves that they will change their spending habits, they usually don’t.  What does end up happening is that they go out and get more credit cards. n addition, creditors that are receiving the regular minimum payments over a period of time, will usually increase your spending limits. What ends up happening is that a person will go back and use that available line as well, all the while thinking that it’s ok because they can make the minimum payments without a problem.

Most people that have started down this path usually have never set up a budget and about one-third to one-half of these people couldn’t tell you what they spent all their money on. Most often, it was for impulse purchases or unnecessary items – the bulk of which, if they took a month or so to save up for, could have easily been paid for in cash.

Before you know it, you have $8,000 – $10,000 – $15,000 or more in revolving credit card debt.  You can make your minimum $300 per month payment, but now, after you pay for your regular cost of living expenses, you have nothing left over for savings or nothing left over to put towards the balance owed on the cards. Nothing left over for an emergency fund or college savings or retirement plan. You now spend each month working and serving your debts.

Auto Loan Debt

Not many people have the thousands of dollars it takes to purchase a car just sitting in their savings accounts. For this reason, auto loans are pretty common. However, since most cars lose value after you buy them, this is usually a bad debt.

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Medical debt is incurred when you are late paying a medical bill. Often, this bill will be sent to a debt collection agency and you will get calls from a debt collector. You have 180 days to rectify this before it shows up on your credit report and affects your credit.

Personal Loan Debt

Taking out any type of personal loan can be risky. Payday loans and loans for non-necessities usually have high interest rates and are difficult to pay off. If you can make the payments and have a legitimate reason, then a personal loan can work out in your favor. However, many personal loans have high interest rates and can lead to debt down the road.

Collections

Lenders often sell debts to collection agencies so they don’t have to deal with you directly. Debt collectors will then call you to try to get you to pay what you owe. These collections accounts can show up on your credit report and could make a negative impression on future lenders.

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Good Debt

How do you get into debt in a good way? It’s pretty simple. You work with a lender to take out a debt with periodic payments you can afford to get an essential thing you couldn’t buy upfront. Good debt refers to any debt that provides something of value that increases your net worth over time.

Mortgage Loan Debt

A mortgage is one of the best debts you can have. Taking out a mortgage makes it possible for you to get the right home for you and your family. Like auto debt, mortgages can continue to be good debt if you make your payments on time.

Business Debt

If you start a business, chances are you will have to take out a loan to do it. With a solid venture, this can be a good debt. If you’re in over your head, it may become bad debt.

Student Loan Debt

An education is an incredibly valuable thing in today’s job market. When you invest in your future by taking out private or public student loan debts, it usually means you can make more money down the road and, hopefully, pay off those loans more easily. Student loan debt counts as good debt because it increases your lifetime earning potential.

Bad Financial Habits That Enable Debt

Debt doesn’t happen on accident, and there are many bad habits that can get you there (and keep you there). Even if you aren’t in debt right now, check to see if you are committing any of these personal finance sins.

Impulse Shopping

We live in a society based on consumption. That’s good news and bad news. The good news is that it’s not your fault that you are programmed to get a little rush of dopamine whenever you buy something or score a good deal. The bad news is if you act on the impulse to shop because it feels good, you won’t feel good about the debt you have from it later.

Living Beyond Your Means

You only earn so much money every month. Some months are more expensive than others, but if you are consistently spending more than you make, then you are living beyond your means. This is a fast track to lots of debt.

Not Budgetingwooden blocks spelling debt and budget balancing on a scale; what is debt?

Failing to budget, or at least track your expenses to some degree, is another quick way to fall into the debt trap. If you aren’t analyzing what you earn and what you spend, how will you even know if you are impulse shopping or living beyond your means? When you budget, you find out where your finances stand. Knowing where you stand is essential to getting and staying out of debt.

Purchase Acceleration

If you have a rewards credit card, you may be guilty of purchase acceleration. Have you ever wanted to rack up points fast, but realized you needed to charge more on the card to get them? This can result in buying more than you can afford just so you can earn the points you want.

How to Tell if You Have Too Much Debt

Confused about whether or not you have too much debt? You aren’t the only one. There are many people that have the wrong idea about their level of debt, but there are a few ways to know if your debt is getting out of hand.

Debt-to-Income Ratio (DTI)

The first way to check if you have too much debt is by calculating your debt-to-income ratio. To do this, divide your total monthly debt payments by your total gross monthly income. Most lenders won’t lend to you if your ratio is 43% or higher. If your ratio is higher than 50%, you likely need some financial help.

Credit Card Debt as a Percentage of Income

You can also find out if you have too much debt by comparing your level of credit card debt to your income. First, add up all of the monthly minimum payments on all of your cards. Then divide that number by your total gross monthly income. If this number is more than 10%, you have more debt than you can handle.

Solutions for Debt

Debt isn’t a life sentence. Once you understand your financial situation and what your debt really means, you can review all of the possible solutions.

Deferment

This solution won’t get rid of your debt, but it can save you money and time. Deferment is an agreement between you and your lender that allows you to pause monthly payments without being penalized.

Forbearance

Forbearance is like deferment, except the periods of paused payments are usually shorter and you will still incur interest. In some cases, the lender simply reduces payments. This solution is most often used for student loans and mortgages.

RefinancingBusinessman using a calculator to calculate the numbers. Accounting , Accountancy; what is debt?

This can be a great choice if you think you can qualify for a lower interest rate. Just make sure that you don’t apply for too many at once, or the multiple new inquiries could bring down your credit report.

Loan Modification

Loan modifications are less common now than they were during the mortgage crisis of 2008. While refinancing changes the interest rate, loan modification alters the term of the loan or the principal amount.

Consolidation Loans

Taking on a consolidation loan means getting one new loan to pay off all your debt at once. Then, you make payments on that loan instead of dealing with all of the individual lenders and interest rates.

Debt Forgiveness

True debt forgiveness is extremely rare. Basically, you are completely off the hook for your debt without any penalties. One common type of forgiveness is student loan forgiveness for a permanent disability.

Workout Arrangements

This solution is only for credit card debt. You and your specific creditor negotiate a plan to help you repay your debt. This helps you avoid a charge-off, but they freeze your account so you can’t charge anymore.

Settlement Agreements

These aren’t the same thing as debt settlement programs. Settlement programs combine many different debts into one payment. A settlement agreement is something you do on your own with one creditor or collector to reduce what you owe on one account.

Voluntary Surrender

Auto loans and mortgage loans have the option for voluntary surrender. The term usually only applies to giving up a car to get out of an auto loan. For houses, there is “deed-in-lieu of foreclosure,” which means you give up your house instead of foreclosing.

Bankruptcy

This is usually the last option for your debt, but it can be a great solution if you already don’t have a great credit score and you need to move on and rebuild. There are two different types of bankruptcy: Chapter 7 and Chapter 13. Chapter 7 is a fast solution that liquidates your assets. Chapter 13 allows you to make a plan to repay some of what you owe before the final discharge.

The Bottom Line

Debt feels all-consuming until you understand it. Now that you know more about what debt is and how it works, you can feel more empowered when looking for the right solution. Knowing how debt and debt relief services function is also the best way to avoid getting caught in a scam. Come back to this guide if you need a reminder about how different aspects of debt really work, and check out the rest of the site for even more information and money tips.

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History of Debt in America

Credit as a form of payment has been around for at least 5,000 years. That’s right – people have been in debt since way before the U.S. was even an idea. While this is a fun fact that may be useful on trivia night, the more recent history of debt in America is much more useful to your financial situation today.

Financial institutions reserved lending for the upper class up until the early 1900s. Most middle and working-class people had no real debts to speak of because banks refused to lend them money. If someone needed a loan, the only real options that they had were to go to a pawnshop or borrow money privately (usually from loan sharks). These carried very high interest rates, most commonly at 120% and often as high as 240% per year.

Collection practices were harsh to say the least.  It was estimated that in American cities with populations over 25,000, about one family in five were victims of loan sharks. Many of these loans had to be paid back through wage assignments, leaving people on a perpetual cycle of poverty. As the United States became a more industrialized nation, people not only needed loans for unexpected costs but also things like washing machines, automobiles and refrigerators – items that were impossible for the common man to make lump-sum purchases for.

It was really this type of growth that spawned the reform of the way people obtained loans.  Around 1910, lending organizations focused exclusively on the needs of consumers. Remedial loan groups formed, to combat the high-rate lenders. The New York State attorney, in an attempt to curb loan sharking, put a great deal of pressure upon banks to make more consumer-type loans available.

In 1928 the National City Bank of New York offered loans with an interest rate of 12% to the working-class consumer. On the first day they received 500 applications.

During the Great Depression of the 1930s, the U.S. government, in an effort to encourage banks to lend money to people for the financing of homes and automobiles, backed and guaranteed the loans. This practice is still around today. In addition, the government continues to back most student loans, loans to open a small business and to operate farms.

Installment credit is not bad when used in balance with income and prudent savings.  The purchase of a home or an automobile surely would not be attainable for the majority of us, if it were not for installment credit.

But what about the credit card? Where did this concept come from?

Initially, it was Frank McNamara of New York’s Hamilton Credit Corporation that came up with the idea of giving affluent businessmen a convenient way to charge some of their business-related expenses. In 1950 he issued the original Diners Club card. It was made out of pasteboard with the customer’s name on one side and a list of twenty-seven restaurants that accepted it on the other. In 1955, they replaced the pasteboard card with one made of plastic.

American Express began issuing cards in 1958, followed by the BankAmericard that was issued by Bank of America. Soon, smaller banks joined the BankAmericard system. In 1977 that card underwent a name change and became Visa. By the 1990s Visa was the largest credit card in use with nearly 400 million cards in circulation and more than 12 million businesses that accepted it. In 1967 City Bank of New York issued the Everything card. It eventually took the new name of Mastercard.

These initial credit cards were simply used as a convenient substitute for cash. You charged and paid the balance in full each month. But during the 1960s the Crest card took hold of the American consumer’s wallet. The card allowed the consumer to use money that they had not yet earned. By doing this, the credit card took a firm hold of the user’s future. This card moved to a revolving payment structure, where the cardholder was only required to pay a small percentage of their balance. Now, instead of paying the bill in-full at the end of the month, the bills began to come month, after month, after month.

Last year Americans racked up close to $1 trillion dollars in revolving credit card debt. Credit card companies make approximately $18 billion dollars a year in fees alone.

Credit card companies have managed to market their services so effectively that they have more than one billion cards in circulation. The average American family carries about 6 to 12 credit cards and carries a balance over $10,000 from month to month, paying an average 18.3% in interest.

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Article last modified on August 20, 2019. Published by Debt.com, LLC