Basic Types of Debt

Debt and instant credit are part of our everyday lives. But what’s the balance between using it wisely and having your debt spiral out of control? Here are the two main kinds of debt and credit that you’re most likely to use, and what they involve.

Installment debt

The money you borrow to purchase large-ticket items, such as homes or vehicles, and pay back over time is called installment debt. A mortgage is an example of this type of loan.

Because you make regular, set payments over a term of months or years up to a determined end-date, an installment debt is easier to budget and track. Here’s how it works:

• You take out a loan for a set amount (the principal) and agree to pay it back with a certain interest rate.
• The loan is then repaid on an amortizing schedule. This means you make fixed payments, usually monthly, over the life of the loan.
• At first, your payments consist mostly of interest. In later years, you pay down more of your principal.

Revolving credit

If you have Visa®, Mastercard® and department store credit cards, you’re using a revolving line of credit or "open-ended credit." The credit card company gives you a credit limit based on your credit payment history and income.

While revolving credit can be convenient, it can snowball. Keep these pointers in mind when you charge with a credit card:

• Each month, you must make a minimum payment based on your outstanding balance. You may also have to pay an annual account fee.

• Be careful about only paying the minimum, however. It may barely cover the interest you owe. You may even see a reduction in your monthly minimum, but, over time, this can make it take longer to pay off your balance … and result in you paying even more interest.

• Annual rates of interest can be high—18% or more.

Revolving credit does have its advantages, though. A card is easier and safer than carrying cash. For young adults, it can be an easy way build your credit and mark you as a good candidate for future loans. Itemized monthly statements can also help you track your expenses.