Understanding the Main Types of Debt
Understanding the main types of debt can help you find the best way to borrow and make repayments. Read on to find out how each type of debt works and whether it could be right for you.
Debt can include a loan to help you buy a house, car, or new kitchen, or money towards your education. It can also include credit cards, which can help you spread the cost of big expenses or build your credit score.
However, not all debt operates in the same way, so it is important to understand the differences before you sign on the dotted line – from how you pay off your debt, and how long you have to do so, to how much it will cost and what happens if you can’t afford to meet repayments.
The two main types of debt
There are two main types of debt: secured and unsecured.
Secured debt is when you borrow money and use a physical asset as collateral, such as a property or car. If you can’t repay your debt, the lender has the right to repossess the asset to pay off what you owe.
Although interest rates on secured debt may be lower than for other types of loan where a lender has no security to fall back on, secured loans are often riskier for the borrower because the consequences of not paying are more serious.
Other types of secured debt include:
Unsecured debt is when you borrow money without having to put down an asset as collateral. Instead, you are likely to be charged higher interest rates or fees to cover the risk to the lender. If you don’t repay on time or in full, you may be charged more interest or fees, and your credit score could be damaged, limiting your ability to borrow in the future.
Types of unsecured debt include:
The cost of many unsecured debts will be promoted with a representative annual percentage rate (APR) which is a percentage figure of how much you’re likely to pay in fees and interest charges for the loan. This varies depending on the borrower. So your APR may be higher if, for example, you have a poor credit history.
It is good to keep in mind that the representative APR promoted by lenders only has to be offered to at least 51% of borrowers, so that rate isn’t guaranteed to all.
» MORE: Tips for getting out of debt
Here are the most common types of debt and the main things to know before you take them on.
Credit cards are one of the most common forms of unsecured debt. They are also an example of ‘revolving’ debt, meaning you can reuse your credit once it has been paid off. Although you must meet minimum payments each month, you do not have a set number of instalments to repay your debt as you would with a personal loan. This means you can repay it at your own pace.
You can spend up to your credit limit on your card, and lenders will decide on your credit limit by looking at, for example, your credit score and income.
Interest is charged when you do not clear your balance in full each month, and the slower you repay the money, the more you will pay overall. As a result, interest rates can be high, though there are a number of 0% credit cards that enable you to spend interest-free for a set period, say 12 months.
Credit cards can be an expensive type of debt if you only stick to making the minimum monthly repayments. But they can also be one of the cheapest ways to borrow if managed sensibly. Keeping on top of your credit card repayments can also boost your credit score.
Personal loans could be useful for borrowing large sums of money and spreading repayment over a longer period of time. Unlike a credit card where the debt has no time frame, personal loans are based on borrowing a fixed amount of money, from a few thousand pounds to up to about £25,000, for a set period, usually between one and 10 years.
You may decide to take out a personal loan for any of the following:
Usually, the longer the term, the lower the interest rate, but don’t be fooled into thinking this will be cheaper. The longer you are repaying interest, the more it adds up. So paying debt down over a shorter period of time may work out less expensive overall.
It’s worth noting that some lenders charge a fee if you pay off your loan early, so it’s important to check the terms and conditions if you’re thinking about clearing your debt ahead of the agreed repayment date.
Offered by the Student Loans Company, student loans provide government-backed cash to UK students studying for their first degree, or postgraduate qualification. You apply before you start your studies and receive the money in instalments each term.
Student loans can be made up of tuition loans to cover your fees and maintenance loans to cover living expenses. How much you get varies according to your fees, your household income and where you plan to live.
You don’t have to start repaying the loan until you graduate and your salary reaches a certain threshold, with repayments fixed at a percentage of earnings above that amount.
Unlike other loans, your student loan may be written off if you haven’t paid it off after a certain number of years. The time it takes for your student loan to be written off will depend on your repayment plan. You can find out more about student loan write-offs on Gov.uk.
Mortgages, or home loans, are considered secured debt. This means that the property you buy is used as security in case you can’t repay what you owe.
Most mortgages require a deposit of at least 5%. Your lender will offer to let you borrow a certain amount of money, which you’ll have to pay back, plus interest, over a specified term. Some mortgages are interest-only, where you clear the capital borrowed in full at the end of the term, but these are increasingly uncommon. Instead, most mortgages are offered on a repayment basis, where your monthly payment covers the interest and pays back some of your original loan amount.
If you want to overpay or clear your mortgage before the end of the term, you may have to pay an early repayment charge. If you cannot pay your mortgage, your home – the security on your loan – may be repossessed.
» MORE: Learn more about mortgage terms
Car finance is a type of borrowing that allows you to purchase, lease or hire a car and spread the repayments. There are four main types of car finance agreements:
- Personal loan: Borrowing money from a lender, usually a bank or building society, to pay for a car. Once you purchase the car, you’ll own it outright. You’ll then repay your lender over an agreed period of time plus interest.
- Personal contract purchase (PCP): With PCP, you pay a deposit of around 10% along with fixed monthly payments for the duration of your contract. The car is owned by the lender. At the end of the contract you can choose to pay the remaining value of the car and keep it, exchange the car or return it to the supplier.
- Hire purchase (HP): You put down a deposit and make fixed monthly payments until the car is paid off. The car will be owned by the HP provider until you’ve made your final payment.
- Personal leasing: This is when you rent a car from a supplier for an agreed period of time. But there is no option to buy the car once your contract ends. Instead, you may be offered the chance to switch to a new car.
An overdraft lets you borrow money through your current account. Some banks offer interest-free overdrafts of a few hundred pounds, but most overdrafts will work out as expensive, with the majority of high street banks now charging 40% interest for those who slip into the red.
» COMPARE: Overdraft bank accounts
Buy now, pay later
‘Buy now, pay later’ has been around in the form of catalogue or store finance for years, but it’s more recently been repackaged by new brands as a type of easily accessible debt offered by online shops at checkout. It allows you either to pay in instalments or to delay paying for your shopping until a later date. Often no interest is charged, as long as you pay the balance owed by the agreed deadline.
If you fail to keep up with instalments or to pay by the scheduled date, you may have to pay interest, fees, or the debt may damage your credit file.
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Laura is a journalist and author, writing about money since 2008. Including writing for The Times for 9 years. She believes finance doesn't need to be complicated. Author of Money: a user's guide. Read more
Brean is a personal finance writer at NerdWallet. She covers a range of financial topics and has written for consumer titles including Which?, Moneywise and The Motley Fool. Read more