Debt is the amount borrowed by one party from another. It is a liability. As such, it has to be taken into account as one calculates their net worth.
Categories of Debt
- Secured Debt: Debt backed by an asset for collateral purposes. For example, one may put their house up as collateral in order to get a loan for business purposes. In the event of default, the house would get repossessed by the bank.
- Unsecured Debt: Debt that lacks any collateral. One is still contractually bound to pay the loan or may be sued in the event of default.
- Revolving Debt: This is an agreement made between a lender and consumer that enables the consumer to borrow an amount up to a maximum limit on a recurring basis. For example, credit cards have a credit limit. One cannot spend beyond their limit. It may be secured or unsecured.
- Mortgage: This is a loan made to purchase a home, with the subject real estate (i.e. the house being purchased) serving as collateral on the loan. It is usually issued as a long-term loan, usually 15 years or more.
There are a number of ways to try and reduce your debts:
- Debt-Snowball Method
- Debt Consolidation
This is a strategy employed to reduce one’s debts. It is common where one owes to more than one account. One pays off the accounts starting with the smaller balances first, while paying the minimum payment on the larger accounts.
How It Is Done:
- List your debts, from the smallest to the largest. This is based on the amount owed, not the interest charged. If two debts are close in amount, the one with the higher interest rate should be moved above on the list.
- Commit to pay the minimum payment on each debt.
- Determine how much extra can be paid towards the smallest debt.
- Pay the minimum payment, plus the extra amount on the smallest debt until it is paid off. Be sure to notify your creditor that this is what you are doing.
- Once a debt is paid in full, add the old minimum payment (plus any extra amount available) from the first debt to the minimum payment on the second smallest debt, and apply the new sum to repaying the second smallest debt.
- Repeat this process until all debts are paid in full.
This involves taking a new loan in order to pay off other debts that you have, usually unsecured debts. Multiple debts are combined to make a larger, single debt with more favourable payoff terms, for example, a lower interest rate.
There are two broad types:
- Secured Loan; these are backed by some kind of collateral
- Unsecured Loan; these are not backed by any collateral
This involves coming up with strategies to better manage your debt situation. This is very important, as debt has serious impacts on your financial situation.
Importance of Debt Management
- Reduce Debt: Managing your debt helps you to reduce any debt you may have.
- Planning how to pay off debt: Debt management helps one to plan and also come up with a budget. This helps to map out a strategy for clearing your debt.
- Better Spending Habits: Debt management helps one to develop better spending habits, especially if your debt is as a result of credit cards.
Tips with debt
- Don’t use credit for anything you can purchase outright with cash.
- Avoid impulse purchases (with regards to credit cards)