Debt, Defined: What It Is And How To Manage It
Victoria Araj7-Minute Read
UPDATED: July 27, 2023
Debt is something we're told to avoid, but the reality is that almost everyone will have to deal with it at some point in their lives. Whether you're preparing to take out a loan or facing down some hefty credit card payments, it's never too late in the game to brush up on your understanding of debt and review your options for successfully paying it off.
What Is Debt?
In short, debt is money borrowed from and owed back to someone else.
Often, debt comes into play with large purchases that a borrower cannot cover all at once on their own. In exchange for the money to make their purchase upfront, the borrower promises their lender that they will repay their debt at some point in the future. Repayment is often made in small installments and usually includes some form of interest.
Debt exists at various levels. Business owners may use loans to finance their companies, and you've likely heard of the government debt that funds countries' expenses. But the debt that will have the most impact on your day-to-day life is on the individual level. These are the loans that control your home, car, college education and any other major expense that you can't immediately pay out-of-pocket.
How Debt Works
Let's say you need to buy a car. It costs $25,000, but you don't have enough in your savings account to cover the purchase price. To get your car, you'll need to go into debt. Here's how that process works.
Finding A Lender
The first thing you'll need to do is find a lender. In this case, you're looking for a lender – either online or at a credit union – that offers auto loans, but the type of lender you'll go to will depend on the type of loan you need.
Before a lender gives you your funds, they'll first assess you to make sure you can pay them back. Lenders often use the following to decide whether you're a trustworthy borrower:
Once you're qualified to borrow, you and your lender will discuss the terms of your loan. These include:
- Repayment period
- Interest rate
In other words, your loan terms are the rules you must follow when repaying your debt. They govern how soon you must pay off your debt, how often you must make installment payments and how much extra you must pay in interest in exchange for borrowing.
Making A Down Payment
Many loans require that you make a down payment in order to borrow from your lender. A down payment is a portion of your loan that you pay upfront. Because a down payment shows a lender that you're likely to repay your loan, a larger down payment often translates to a lower interest rate.
Understanding Principal And Interest
Debt has two components: principal and interest. The principal is the amount of money you borrowed. In the auto loan example, the principal is the $25,000 purchase price of the car. Interest is extra money you pay your lender in exchange for letting you borrow the principal.
Each time you make a payment towards your debt, you'll repay a portion of the principal, and the rest will go toward interest. At the beginning of a loan's life, more will go toward interest. Gradually, you'll pay more toward the principal – as the principal goes down, the less your interest will grow.
Going Into Default
Hopefully, you won't have to deal with going into default – defaulting on your loan only happens when you break the terms of your loan and are unable to make payments toward your debt. When you set up your loan, your lender will provide you with documentation that outlines the consequences of default. In the case of an auto loan, this might include repossession of your car. In some cases, default can also result in bankruptcy.
Types Of Debt
There are two major categories of debt: secured and unsecured. Within these broader categories are specific types of debt. These are usually differentiated by the purpose for borrowing, whether that be to buy a home or pay for medical bills.
Secured debt is debt that includes collateral. Lenders have more protection in the case of a secured loan because borrowers have pledged an asset as collateral. In a mortgage, for example, the collateral is a house. If the borrower defaults on their payments, the lender can foreclose on the house and recoup their losses when a buyer purchases the home.
Secured Debt Includes:
- Auto loans
Borrowers offer no collateral in the case of unsecured debt. While you don't have to worry about repossession in these cases, the penalties for defaulting are still high and include debt collection, lawsuits and wage garnishment.
Unsecured Debt Includes:
Paying Off Your Debt
In most cases, paying off your debt will be a simple matter of sticking to the repayment plan set up by your lender. If you have revolving debt – like a credit card – your regular payment will vary depending on how much you've used. Installment debts like a mortgage will generally have a regular monthly payment that recurs until you pay off your debt.
But what if you're having trouble keeping up with your debt? These strategies can help you get back on top of your payments, whether you're just beginning to fall behind or are reaching a point of crisis.
There are a few quick fixes you can apply if you're in the early stages of managing your debt. Maybe you've just taken out a loan or have taken on some new expenses. The first step you should take is to make a budget.
Make sure you take all your spending into account and try to trim where you can – for example, you might have some subscriptions and services that you pay for monthly but don't use. Even if you're already living as lean as you can, making a budget will be essential for some of the next debt management steps.
Debt consolidation involves combining all of your payments into one. This makes debt repayment simpler to manage and may also offer lower interest rates and lower monthly payments. Debt consolidation often operates as a type of personal loan, so you'll need to find a lender who can offer you terms that make combining your debts worthwhile.
If you're considering debt consolidation, make sure you review how it differs from debt settlement so you can choose the strategy that works best for your situation.
If you know how much you need to cut back on loan payments to make all your financial commitments each month, you can try contacting your lenders and creditors to explain your situation. You may be able to refinance your loan to make your payments more manageable, and most mortgage lenders will work with you to avoid foreclosure if you need to temporarily adjust your payments.
Credit counseling organizations can help you navigate your debt by setting you up with a personalized financial plan. They also often offer education sessions and workshops. If you don't know where to start, consulting a reputable counseling organization may be a good step. Just make sure services are free or at least affordable before signing on.
Debt Management Plans
Debt management plans (DMP) are a step up, and they're often best reserved for after you've already exhausted your other options. DMPs involve a third party – usually your credit counseling organization – that acts as a go-between for you and your creditors. You'll make monthly payments to the counseling organization who will in turn make payments to each of your creditors.
DMPs can take years to complete, and you'll need to carefully check all the rules before enrolling, as some plans may limit your credit use.
Debt settlement programs are similar to DMPs, but instead of making monthly payments split between creditors, you'll make a single lump sum payment after saving month by month according to a plan set up by your settlement provider. They will then negotiate with your creditors and use your accumulated funds to call off your debts.
It's important to note that there are significant risks involved with debt settlement:
- If your budget isn't rock solid before enrolling in a program, you might not be able to make all your monthly payments and could be forced to drop out before resolving any debt.
- Your creditors aren't obligated to negotiate with your debt settlement company, so you may not be completely covered by your program.
- You usually agree not to pay your creditors directly, meaning your credit score may be negatively affected.
- Late fees may still apply and accumulate.
- Creditors may still have the option to sue for repayment.
Bankruptcy is a last resort, but if you have too much debt and truly don't have other repayment options, declaring bankruptcy can offer you a new start by discharging your debts. Just make sure you understand the drawbacks. Bankruptcy remains on your credit report for 10 years and can impact your ability to:
- Buy a house
- Get a credit card
- Buy insurance
- Get a job
You have two options in personal bankruptcy court: Chapter 13 and Chapter 7. Chapter 13 bankruptcy gives you a multi-year repayment plan and allows you to keep physical assets like your car and house. If you don't qualify for Chapter 13, you'll have to declare Chapter 7 bankruptcy, also known as "straight bankruptcy." In this case, all your non-exempt assets can be liquidated to resolve your debt.
Debt Scams To Watch Out For
Unfortunately, there are plenty of disreputable businesses that try to take advantage of those struggling with debt. Before enrolling in any non-government program, make sure you do your research and fully vet it to confirm that it's a legitimate organization.
Here are a few tips:
- Try consulting a local consumer protection agency before signing on with any debt relief service.
- Find out exactly what services are provided and how much they cost before starting a program.
- Get everything in writing (and read EVERYTHING before signing on the dotted line).
- Look for hidden fees and beware of companies that ask for voluntary contributions.
- Don't trust a company to fully communicate the risks of their service.
- Avoid services that charge fees before settling debt or starting you on their DMP.
- Verify claims of new government programs with an actual government agency.
Some companies may try to make you feel desperate in order to sign on with them, but no matter how critical your situation is, remember that you always have time to vet a program or service before committing to it. Take advantage of your local government programs to ensure you're protected every step of the way.
If you want to buy or renovate a home, get a car or graduate from college, you might have to deal with debt. While the prospect of defaulting on a loan is scary, debt in one form or another is a normal part of life for most people. Some debt, like your mortgage or a debt consolidation loan, is even considered "good debt" because it can help you build wealth over time.
In some cases, though, getting out from under your debt may feel impossible. Just remember that you have options when it comes to paying off your debt. The sooner you get started, the sooner you'll feel in control of your finances again.
If you're ready to take the next step to move financially forward and consolidate your debt, you can apply for a personal loan online today.
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