Mortgages, auto loans, student loans, credit cards… debt is not uncommon.
Mortgages, auto loans, student loans, credit cards… debt is not uncommon. It is likely you will have some form of debt that requires regular monthly payments at some point during your lifetime. According to debt.org, the average American has approximately $137,000 in debt which covers everything from mortgages to credit cards. In 2018, the amount of debt across the country totaled over $13 trillion!
Within the space of personal debt, there are two major categories: revolving debt and non-revolving debt. Understanding the characteristics of these two types will help you better manage your debts as well as gauge the impact debt has on your credit profile, ultimately saving you money over time.
You’re probably more familiar with revolving debt than you think. Credit cards and lines of credit, such as a home equity line of credit, are the most common forms of revolving debt. Revolving debt gets its name from the fact that the debt can be paid in full or the outstanding balance (the amount you owe) can be rolled over each month.
This type of debt is extended to qualified borrowers with a specific limit on the amount that can be used. If you’ve ever opened up a credit card you will know that: (1) they will ask for a lot of information about your history to confirm you are “qualified;” and (2) along with your shiny new card, you will receive a maximum amount you can borrow. As you continue to pay your credit card bills on time, your good credit history gets longer, and the credit card company is likely to let you borrow more or have a higher maximum credit limit.
With revolving debt, your limit, required payments, and interest rates are subject to change. Depending on your balance, you will typically have a minimum payment that will be required each month. If you don’t pay the full amount that you owe each month, you will carry a balance forward. When this happens, the credit company charges you interest on the remaining balance which can not only extend the time that it takes to pay off your balance, but also increase the amount you owe over time.
Let’s look at an example:
For someone who pays their credit card balance in full each month, they are in effect borrowing money for free with no interest paid on their revolving credit month over month as seen in the table below.
However, if someone were to start with the same balance, but only paid the minimum balance due each month, the amount of interest they would owe for their revolving credit would quickly add up. This approach can be costly over time:
Revolving debt has a huge impact on your credit score because these loans have a great deal of flexibility for the borrower (you) and balances can grow quickly, adding risk for the lender. The inability of lenders to predict how you will use your credit limit is also the reason why these types of debt have higher interest rates compared to other types. Seek to keep your balances low compared to what you are allowed to borrow for each type of revolving credit. The ratio of how much of your credit you are using (your current balance) to how much you have available (your credit limit) is referred to as your “credit utilization.” Low credit utilization = higher credit score.
The other major type of debt is known as non-revolving, or installment debt. The most notable difference between non-revolving and revolving debt is that as the balance is paid down for non-revolving debt, you cannot borrow again to purchase other things. Once you repay the loan, the account is closed. If you desire to borrow again, you must reapply and there is no guarantee that you will be approved for the same terms. Examples of non-revolving debt include student loans, auto loans, and mortgages.
Non-revolving debt typically offers lower interest rates that are agreed upon at the time you apply for the loan. This provides a high degree of predictability because your payments and interest rates will not change as you repay the loan. Because of this, this type of debt is usually to fund larger long-term purchases. It’s important to note that because the lender is expecting a certain amount of interest income from your loan, some loans may come with a “prepayment penalty.” A prepayment penalty is a fee if you pay your loan off early. Check to see if your loan contains this penalty before securing the paperwork. If there’s a possibility that you will want to pay the loan off early, try to get the penalty taken off.
Outside of the two major types of debt, there is another factor to consider before borrowing – the difference between secured and unsecured debt.
Secured debts use an asset like a home or a vehicle as collateral for what is owed. This gives the lender the ability to repossess or foreclose on the asset to repay the debt if you stop paying the loan.
With unsecured debt, there is no asset pledged to back up the debt. If you can’t repay the debt, the lender can only report your failure to pay to the credit bureaus or send the debt to collections in order to recover their money. This would be how a credit card or medical bill delinquency would be handled.
It is possible, however, to have revolving debt that is also secured such as with a home equity line of credit (HELOC) in which you have an open line to funds and your home is collateral. Additionally, with non-revolving debt you can have unsecured debt like a personal or student loan.
Here is a chart to help you visualize each type of debt.
Each type of debt, revolving and non-revolving, are useful in different ways. Revolving debt is used when you aren’t sure how much you might need over time, and non-revolving might help you with a one-time large purchase.
Your ability to repay your debt is the most important factor to consider when borrowing money. When you are evaluating whether to borrow, make sure you understand the terms of the debt such as payment amount and interest rate when taking on the debt, as well as your ability to make the payments to pay the debt off. Remember your budget when considering taking on debt. The 50/30/20 rule is a good guideline to help you determine if you will still be able to save the target amount once you take on this debt.