The Basics: Debt Education

Before you dive into the debt reduction process it is important to understand that there is debt that can be used for investing in the future (such as education or a business), debt that can be used for investing in appreciable assets (real estate), and debt that can be used for consumer spending. Although all debt can be dangerous if not structured and used properly, consumer debt can be particularly harmful to your financial health.

What is Consumer Credit:

Consumer credit consists of mortgage loans, auto loans, credit cards, store cards, and personal loans. Terms of these loan types vary based on the type of loan, your credit score and payment history, amount of credit offered, whether or not the loan is secured, and etc. These types of loans generally require making payments according to a schedule. Late or missed payments will usually incur higher interest rates, loss of benefits (such as with cash back and airline mileage points), and late reports to credit bureau companies. Generally if credit is not paid off within the specified period of time, interest and/or a late fee is charged on the outstanding balance. Repayment of credit along with the interest charge depends on the type of credit taken. The basic types of loans include:

Close-ended loans: These types of loans are known as installment loans. Close-ended loans include mortgage loans, auto loans, and student loans. The lender of these types of loans will typically grant a fixed loan amount, interest rate and monthly payment. Monthly payments are generally equal monthly installments made up of a principal reduction portion and an interest portion. In most cases with mortgage and auto loans, a down payment is required at the origination of the loan. Close-ended loans are not intended to be revolving credit loans and as such do not provide flexibility to you as a borrower. Keep in mind that these loans may be secured by the assets that are being financed. If this is the case, the asset may be repossessed in the event of non-payment of the applicable loan.

Open-ended loans: These types of loans are referred to as revolving credit loans. Credit cards and home equity loans are the most common examples of open-ended loans. Credit cards come in the form of bank credit cards such as American Express, Master Card, and Visa, retail charge cards such as department store cards and gas station cards, and entertainment cards such as Diners Club cards. Home equity loans generally have a credit limit that is secured by the borrower’s real estate. With revolving credit loans, you can borrow funds repeatedly up to your available credit limit. Repayment terms on credit cards are usually geared to the lowest amount necessary to pay the interest on the outstanding balance. Because of this, the principal balance of your credit card debt doesn’t get paid off for years and is constantly accumulating interest.

Secured or unsecured loans: Auto loans, home mortgage loans, home equity loans are examples of loans that are normally secured by the assets being financed. This simply means that the assets being purchased or financed are used as collateral for the underlying loans being granted. Credit cards and other non-real estate related revolving credit loans are generally not secured by collateral. All loans granted to you are done so with the expectation that you will repay them according to their terms. Regardless of whether or not the loans are secured, non-payment or late payment will almost certainly result in action taken by the credit grantor. Loans that are secured allow the credit grantor to repossess the asset in the event of a violation of the terms of the loan agreements.

When evaluating loans, make sure you clearly understand the type of loan and terms of repayment in order to determine whether or not they fit your goals and expectations.

Many people take on the burden of debt without fully understanding their conditions. Others take on debt and then their personal circumstances change due to things such as unemployment, divorce or the death of a family member. These circumstances may result in late payments or even default on debt. There are many resources that can help with situations such as these. Explore the following sections for some solutions to these issues.