It is likely that during your lifetime you will have some form of debt that requires regular monthly payments. Mortgages, auto loans, student loans, and sometimes even credit card debt are not uncommon. According to debt.org, the average American has approximately $137,000 in debt which covers everything from mortgages to credit cards and in 2018 the amount of debt across the country totaled just over 13 trillion dollars!
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 on your credit profile ultimately saving you money over time.
What is the difference?
Although you may not have known, you may be more familiar with revolving debt than you think. Credit cards and lines of credit (think, a home equity line of credit) are typically the most common forms of this type of debt. A revolving debt gets its name from the fact that the debt can be paid in full or the outstanding balance (how much 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 which is referred to as your credit limit. If you’ve ever opened up a credit card you will know that (1) they need to know more about your history to confirm you are “qualified” and (2) along with your shiny new card you receive a maximum that you can borrow. As your good credit history gets longer, your credit line can increase too.
With revolving credit, the amount of your balance, payments, and interest rates are subject to change. Depending on your loan balance you will typically have a minimum payment that will be required each month. If you don’t pay off your credit in full each month, however, you will carry a balance forward. When this happens you will see interest charges added to the balance which can extend the time that it takes to pay off your balance.
Let’s look at an example:
Revolving debt has a huge impact on your credit score. You should seek to keep the available credit you have high by keeping your balances low. The reason for the impact is that these loans have a great deal of flexibility for the borrower (you) and balances can grow quickly adding risk to the lender (this would be the credit company like Chase or WellsFargo). The inability of lenders to predict how you will use your credit limit is also the reason why many of these types of debt have interest rates that are on the higher end of the spectrum, when compared to other debt.
Non-Revolving or Installment Debt
The other major type of debt is known as non-revolving or installment debt. The most notable difference, when compared to revolving debt, is that as the balance is paid down your credit availability is reduced to prevent further borrowing. Once you repay the loan the account is closed and you must reapply if you desire to borrow again with no guarantee that you will be approved for the same terms.
This type of debt typically offers lower interest rates that are agreed to at the time you apply for the loan. This allows for a high degree of predictability because your payments and interest rates likely will not change as you repay the loan. Due to the high degree of predictability for lenders, these types of debt are usually to fund larger long-term purchases. Examples of non-revolving debt include student loans, auto loans, and mortgages.
Some of these loans may come with a “prepayment” penalty that actually charges a fee if you pay it off early. You do not see this with revolving debt so it’s important to see if your longer-term loan may have this in the event you want to pay off early.
What else do I need to know?
Outside of the two major types of debt, there is another factor that should be looked at prior to borrowing.
Secured vs. Unsecured Debt
Secured debts use an asset like a home or a vehicle as collateral for the debt. This gives the lender the ability to repossess or foreclose on the asset in order to repay the debt in the event that you stop paying.
With unsecured debt, there is no asset that is pledged to back up the debt. In the event that you are unable to repay the debt, the lender is limited to reporting the delinquency to the credit bureaus or sending the debt to collections in order to recover the debt. 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.
We made a chart to help you visualize each type of debt\
How can I use this information to help me organize my debt?
In general, we will always want you to focus on your most expensive debt first. As we discussed, this is typically going to be your unsecured debts. The long term cost of unsecured debt is going to be larger than a secured debt of the same size, however, if you find yourself in a situation where you need to prioritize which debts to repay (and which to default on) you should always prioritize secured debts over unsecured debts. If the bank has the ability to seize any of your property if you don’t pay, you’ll want to focus on this first. That said, if you default on any loan it can impact your credit profile and therefore make it harder to borrow in the future.
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. However, your ability to repay your debt is the most important factor to consider when borrowing of either type. When you are evaluating borrowing, make sure you understand the terms of the debt such as payment amount and interest rate when taking on the debt.
If you have any questions about your current debt or debt you might be taking on in the future please reach out to your Origin Planner.