Credit And Debt Defined
Credit And Debt Defined
Janet Bodnar (Deputy Editor, Kiplinger’s Personal Finance) gives expert video advice on: What are the different types of debt?; What is the difference between a "fixed rate loan" and a "variable rate loan"? and more...
What is "debt"?
Debt is simply money that you owe, money that you've borrowed to make a purchase. Debt can be money that you've borrowed to buy a house, a car, credit card debt, that sort of thing, student loans; anything like that is debt, but what people really need to keep in mind is that there's good debt and there's bad debt. Good debt may be something like your mortgage, where you're borrowing money on an asset, your house that is going to appreciate in value. Bad debt is something like credit cards. Using it to buy pizza, which is gone as soon as you've eaten it. Or perhaps you buy clothing, which is a depreciating asset as soon as it leaves the store.
What are the different types of debt?
There are two kinds of debt that people should be aware of. One is called installment debt and one is called revolving debt. Now, installment debt would be a debt which is a fixed amount of money for which you make a, usually a fixed payment. It might be a mortgage or your car loan. Then you have your revolving debt. That is debt that changes from month to month. For example, credit card debt is the most obvious example of something like that. You could owe a certain amount one month and a different amount the following month, depending on your payment schedule.
What is "principal" and what is "interest"?
Principal is the actual amount of money that you borrow. For example, suppose you're taking out a mortgage and you take out a mortgage for $300,000. That would be your principal. Interest is the amount of money that you're going to pay the lender for the privilege of taking out that loan, and it's usually quoted as a percentage rate. So, it might be 6% on a mortgage loan. Or if you have a credit card, it might be 13% or 14% on that.
How is interest calculated?
Interest is calculated as a percentage of the amount of money that you borrow. The interest is paid to the lender, the person who's actually lending you the money. But it's quoted as a percentage rate. It could be six percent on a mortgage; it could be fifteen percent on a credit card. But it's always expressed, legally at least, as an annual percentage rate. That is what it would translate to if it were quoted as an annual rate, if you were paying it annually. And that is a good way of comparing interest rates on various loans because you know you are comparing apples with apples. So if you're looking for the lowest APR (annual percentage rate) on a mortgage, you can use that rate when you're comparing mortgages. If you're looking for the lowest APR on a credit card, you can do the same thing.
What is the difference between a "fixed rate loan" and a "variable rate loan"?
A fixed rate loan has a fixed rate of interest, which means that the interest rate is going to be the same throughout the entire term of the loan. So if you have a fixed rate mortgage at 6%, you're going to be paying 6% for the entire term of the loan. A variable rate loan, on the other hand, has an interest rate that changes. Usually that interest rate is attached to or based on some benchmark, such as the prime rate, and it's going to adjust periodically, perhaps semi-annually or annually. If it's a credit card, it might adjust more frequently than that. It depends on the term of the loan.
What is an "unsecured debt"?
An unsecured debt is a debt that is not secured by any kind of property. For example, a mortgage is a secured debt because the mortgage is secured by your home. A car is a secured debt because it's secured by the car. But, if you go out and just spend money on dinner, and other types of things that you use your credit card for, that's unsecured debt. There's no property to back up that debt.