Understanding the Main Types of Debt

There are two types of debt: secured and unsecured. How best to handle it depends on the type of debt you have.

Laura Whateley Published on 21 April 2021.
Understanding the Main Types of Debt

Debt can include a loan to help you buy a house, car, or new kitchen, or money towards your education, as well as credit cards to help you spread the cost of big expenses or build your credit score.

However, not all debt operates in the same way and it is important to understand the differences before you sign on the dotted line, from how you pay off your debt, how long you have to do so, to how much it will cost, and what happens if you can’t afford to meet repayments.

Secured and unsecured debts

There are two main categories for debt: secured and unsecured.

Secured debt is where you take out a loan or borrow money against a physical asset such as a property or a car. If you fail to repay the agreed loan, the lender can repossess the asset. Interest rates on secured debt are lower as a result, but they are also riskier for the borrower because the consequences of not paying are more serious. Failure to meet repayments may cost you your home. A good example of a secured debt is a mortgage.

Unsecured debt, like personal loans, don’t involve any assets; instead, you are 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 record could be damaged, limiting your ability to borrow in the future.

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 by borrower, 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 necessarily guaranteed to all.

» MORE: How to get out of debt

Here are the most popular types of debt and the main things to know before you take them on.

Credit cards

Credit cards are one of the most common forms of unsecured debt. They are also an example of “revolving” debt, meaning you can reuse the credit you have 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, which will be dependent on things like 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. 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 get a bad rap, and they can become expensive if you fail to clear anything beyond the minimum monthly repayments. But they can also be one of the cheapest ways to borrow if managed sensibly. Many won’t charge any interest if you pay off your balance each month. Rewards credit cards offer points or cashback for spending on them regularly and clearing balances in full. Credit cards, when used responsibly, can also help boost your credit score, as long as you clear them in full and, as a rule of thumb, aim not to use more than around 25% of your credit limit.

Personal loans

Personal loans may be badged up as home improvement loans, further education loans, debt consolidation loans or wedding loans, but they all operate in a similar way. 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 a year and 10 years.

Interest rates may be lower than credit cards as a result, but they are fixed so you will pay a set amount each month over the term of the loan. Some loans will not let you repay loans quicker than the term, or will charge you a fee for doing so. 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. Paying debt down as quickly as you can will generally work out less expensive overall.

Student loans

Offered by the Student Loans Company, student loans offer 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.

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. Any outstanding loan is wiped after 30 years, so those who earn very little will never repay, and many people won’t repay in full.

Mortgages

Home loans or mortgages are considered secured debt, loans that you are taking out against a property you want to buy. It means that you don’t technically own your property outright until you’ve paid off the mortgage.

You cannot borrow the purchase price of the property and will need to put down a deposit. You usually need to put down at least 10% but if you can put down more you are likely to get a lower interest rate and a wider choice of lenders. There are 5% deposit mortgages available as part of the government's mortgage guarantee scheme.

You’ll agree to borrow a fixed sum for a fixed term, and be charged an amount of interest to do so. Each month you’ll have a certain amount to repay, made up of the capital and interest. Some mortgages are interest-only, where you clear the capital borrowed in full at the end of the term, but these are increasingly uncommon.

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.

Car finance

The vast majority of cars are borrowed in the UK, usually using personal contract plans (PCP). These PCP loans enable you to borrow an amount based on how much a car will be worth at the end of the PCP term, usually about three years. You pay a deposit, typically around 10%, and then repay the remaining borrowed sum in monthly instalments for a pre-agreed number of months, plus interest. At the end of the term, you give the car back or buy it using “a balloon payment”, which is a sum agreed at the outset of the deal. This usually works out as more expensive than buying the car outright but enables people to drive cars that they may not usually be able to afford by spreading the cost.

» MORE: The different types of car finance explained

Overdrafts

Most current accounts come with an overdraft, an amount you can borrow if you run out of cash. Some banks offer interest-free overdrafts of a few hundred pounds, but most will work out as very expensive, with the majority of high street banks now charging 40% interest for those who slip into the red.

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 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, you may have to pay interest, fees, or the debt may damage your credit file.

Image Source: Getty Images

About the author:

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

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