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Understanding Debt
 Jun 08, 2004

In order to be able to manage your debt you must first be able to understand debt. This article will define basic debt terms, explain different types of debt, and give you tips on how to tell if you have a debt problem. Understanding debt can help you avoid debt.

Debt is one of the most pervasive things in our society today. It is very important to understand the basics of debt. Whether you have a debt problem or not, more knowledge of what is involved is a good idea, since it can help you make better, more informed decisions.

Basic debt terms

The first part of understanding debt is knowing basic debt terms. Most of these have to do with who is involved with your debt:

  • Debtor: This is someone who has any sort of debt. If you are a debtor, you have borrowed money. It is not money that you actually have on hand. Rather, you get it from someone else. These debts include credit cards, mortgages, personal loans, car loans and even medical bills. A debtor not only pays back the amount borrowed, but also pays interest.
  • Interest: Interest is basically a fee that the debtor is charged for the privilege of borrowing the money. It is kind of like a service fee. Interest is usually expressed as an annual percentage of the money borrowed. For example, if you borrow $1,000 at an interest rate of 12%, you will pay $120 a year in interest. However, most interest is figured on your balance each month. So, as your balance goes down, so does your interest.
  • Creditor: This is the person that the debtor owes money to. This is the bank, credit card company or other lender. The creditor makes money on the interest that the debtor pays.
  • Debt collector: In some cases, the debtor may not be making payments. If this is the case, the creditor may hire someone else to collect the debt for them. Either the debt collector gets a percentage when the debt is finally discharged, or the debt collector buys the debt at a discount from the creditor and keeps whatever is recovered.
  • Third-party financial assistance: If a debtor needs help paying off debt, creating a debt payment plan or wants help with credit repair, he or she may go to someone not initially connected with the original transaction. Many third-party financial assistance programs are non-profit or are funded by governments and others.

Types of debt

It is very important to understand the differences between the two main types of debt. Understanding debt can help you learn about which types of debt will work better for you.

Unsecured debt: This type of debt is debt that is not tied to anything tangible. You borrow without anything to back it up. Credit cards, medical bills and signature loans are examples of unsecured debt. If you default, your creditors can sue for repayment, and take what you have available in capital. However, they can't take any of your tangible assets, such as your home, and you cannot be forced to sell your home to pay off unsecured debt.

Secured debt: On the other hand, secured debt is tied to assets. If you get a car loan, the debt is secured by your car. A mortgage is secured by your home. In some cases, a secured credit card may be tied to a savings account that must maintain a minimum balance. With secured debt, the creditor can take your asset if you default. If you don't make car loan payments, the car is repossessed. If you miss enough mortgage payments, your home is foreclosed upon.

As you might guess, unsecured debt carries a higher interest rate than secured debt. This is because there are not fallbacks for creditors if you fail to pay. Creditors can recover a great deal of their losses if you fail to pay on a secured loan. Unsecured debt is riskier. However, it is also easier to get, since it is usually in smaller amounts, ranging from $500 to $5,000. Secured loans are usually for much larger amounts.

How can I tell if I have a debt problem?

When you are in debt, paying interest charges, it can be a drain on your resources. Often, when you pay only the minimum, most of your payment goes to interest, and the debt only gets smaller at a slow rate. If you have a debt problem, it can put a serious strain on your financial situation. It is important to recognize the signs of a debt problem:

  • You find yourself barely able to meet the minimum payments each month.
  • You regularly borrow money from friends and relatives to make ends meet.
  • You use credit cards regularly to get through the month, without paying the balance off.
  • Your debt doesn't seem to be decreasing.
  • You feel stress about meeting your obligations.

If you have a debt problem, you may need to create a plan to eliminate your debt, or seek third-party financial assistance. But the first step is understanding debt.

Related Article: Debt Options and Reduction >>

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