Debts come in many different forms, but most of them fall into broad categories. The major categories are security and total amount. Collateral here refers to the lender’s security and how they can get their money back if you do not pay.
Total refers to whether the amount you borrow stays fixed or changes (i.e., you can borrow more money for the same loan). Both factors affect the interest rate on the loan.
Secured VS. Unsecured Debt
One key to categorizing debt is based on what’s behind the debt, backing it up. Debt can be either secured or unsecured depending on whether or not the lender has a claim on some sort of property. That distinction can have a great effect on interest rates, as it speaks to the lender’s overall risk in lending the money.
From a borrower’s perspective, paying secured debts takes top priority when there’s not enough money to pay every bill. Though these payments often take up more of the available budget, you stand to lose crucial assets (like your home or your car) if these debts are not paid regularly.
Secured loans are backed by some form of collateral, which is property (like a car or a house) pledged to satisfy the debt if the loan is not paid. With this kind of loan, the lender will place a lien (a claim on an asset) on the collateral that allows them to take it if the borrower doesn’t pay. For example, the lender could repossess a car or foreclose on a house.
The collateral doesn’t have to have any relation to the loan, though it usually does. For example, a car loan usually comes with a lien on that car. Collateral can be pledged to secure loans not tied to any particular asset (for example, some personal loans may require collateral). Because of the built-in safety net, secured loans (from reputable lenders) typically come with lower interest rates.
“Collateral” usually refers to things like cars, houses, and investment securities, but they’re not limited to these assets. As long as the lender agrees, anything of value can work. Some more creative choices include designer handbags, wheels of Parmesan cheese, thoroughbred horses, and star soccer players (on Real Madrid).
Unsecured debt doesn’t come with the security of collateral. Here, the lender is banking on your ability and willingness to make all of the scheduled payments. Examples of unsecured debt include:
- Student loans
- Credit card debt
- Personal loans
- Medical bills
Technically, payday loans fall into the unsecured debt category, but this isn’t exactly correct. While there’s no physical collateral (like a car or a house) pledged to the payday lender, borrowers do have to provide direct access (through a post-dated check or an ACH withdrawal, for example) to their paychecks when they arrive.
Revolving VS. Nonrevolving
Revolving and nonrevolving describe the way money is borrowed. Revolving debt allows you to borrow money at will, up to a preset limit, and then borrow that money again as often as you like. Nonrevolving debt refers to a one-time loan for a fixed dollar amount, and once it’s repaid, you can only borrow again by applying for a new loan.
Revolving debt makes up about 25 percent of the total outstanding US consumer debt in dollars (as of May 2019, according to the Federal Reserve). That’s because individual nonrevolving loans tend to be bigger, covering big- ticket items like mortgages, student loans, and car loans.
With revolving loans, such as home equity lines of credit (HELOCs) and credit cards, your balance due goes up and down depending on your financial activity. You can borrow more at will, up to your limit, and your monthly payment amount can vary based on the current outstanding debt.
Revolving debt is sometimes referred to as open-ended debt, because you can borrow the same money repeatedly. As you make payments, your available credit increases; as you borrow more, your available credit decreases.
Even though you can only borrow up to the maximum credit limit at any given time, you can borrow much more than that over time. Revolving debt can be secured, such as a HELOC secured by your home, or unsecured, such as credit card debt.
With a nonrevolving loan, you borrow a set amount of money in one shot, and the lender expects to be paid back according to a schedule. These loans are predictable, come with planned payments, and have predetermined payoff dates.
Both parties know from the start when the loan will be paid in full. If you need more money, you have to start the process again from the top and take out another loan. Examples of nonrevolving debt include car loans and mortgages.
In most circumstances, the outstanding balance of a nonrevolving loan will only decline over time. (The exception is a loan with negative amortization, when unpaid interest gets added to the balance of the loan.) Nonrevolving debt can be either secured or unsecured.
Learn more about how to manage your debts.