Debt 101 Terms

Secured debt requires the borrower to put up collateral to get the loan. Collateral can include assets, such as a home or car, that a lender can seize in the event the borrower defaults on the loan. The most common types of secured debt include mortgage and car loans. Since lenders require collateral to reduce the risk of default, these loans typically have a lower interest rate than a credit card or unsecured debt.

Unsecured debt, which includes personal loans and credit card debt, doesn’t require collateral to secure the loan. These loans carry a greater risk to the lender because they aren’t guaranteed by personal assets. Since the lender has less protection if a borrower defaults, unsecured debt typically has higher interest rates than secured debt — often going as high as 36% of the amount borrowed.

Installment Debt: With installment debt, borrowers pay a fixed amount each month to their lender. The most common types of installment debt include car, mortgage, and student loans. The major advantage of installment debt is that borrowers know exactly what their payments will be each month, which allows for better financial planning and budgeting.

Revolving debt, which includes credit cards and a home equity line of credit, involve open-ended accounts that don’t have fixed monthly payments and come with a set credit limit. The interest rate on revolving debt changes from month-to-month (variable) and borrowers pay a different monthly amount based on the percentage of their unpaid balance and interest accrued each month. Most revolving debt is unsecured and is easier to get than other forms of consumer credit. If used wisely, it can help borrowers build or repair their credit. However, because revolving debt is readily accessible, it can be easy for borrowers to misuse it and damage their credit score.

Open Debt: Most consumers aren’t familiar with this term, but similar to revolving and installment debt, open debt also appears on your credit report. However, open debt differs in that it occurs and is paid in full every month. Examples include your cell phone bill and paid-in-full credit card products like the American Express Green card.

Interest Rate Terms

Fixed Interest Rates: Compared to variable interest rates, fixed interest rates result in borrowers paying less interest over the life of the loan because the rate doesn’t fluctuate as the market changes. Lenders determine the fixed rate for a specific loan based on several factors, including a borrower’s credit history, credit score and market rates available at that time. Mortgages and student loans can have either variable or fixed interest rates. However, because these loan terms are longer — 15 or 30 years, for example — it is in consumers’ best interest to opt for a fixed-rate loan. When the demand for credit is lower or the supply for credit is higher, consumers can get better interest rates. Consumers with good credit scores (typically 700 or higher) also get better interest rates, which reduces interest expense and the overall payoff amount over the life of their loan.

Variable Interest Rates: A variable interest rate changes as market interest rates fluctuate. It is based on an index that is affected by market conditions and on a credit-based margin the lender determines. Borrowers with good credit often get a lower margin. Variable interest rates are sometimes lower than fixed-rate loans at the beginning of the loan or borrowing term but increase over time. The initial rate a borrower receives will change after a predetermined adjustment period. After this period ends, the interest rate will fluctuate from year-to-year as the market index changes. However, the federal government puts protections in place so that borrowers aren’t subject to huge rate adjustments that can make it more difficult for them to pay off their debt. These protections — known as a cap — limit how much the interest rate increases during each adjustment period and over the loan term.

Annual Percentage Rate (APR) represents the actual yearly cost of borrowing over the term of a loan. APR is usually conveyed as a single percentage number. The APR includes the interest rate applied to the amount borrowed and finance charges that lenders pass onto consumers as part of their cost of doing business. Divide the APR by 12 to figure out the monthly interest that will be applied to your existing balance or by 365 to determine the daily percentage rate (also called the periodic interest rate) to determine the interest that will accrue on your unpaid balance every day. For example, if a credit card issuer offers you a card with a 13.99% APR, the interest you pay every month is about 1.17%. APR is a good way to compare the cost of similar loans that different lenders offer.

Credit Score Terminology

FICO is an acronym for the Fair Isaac Corporation. Your FICO score is the single most important metric for borrowers. It’s what lenders use to assess the risk of loaning you money. Your credit score is comprised of five things:

• Your payment history (35%)
• Current debts (30%)
• Length of your credit history (15%)
• New credit applications (10%)
• Your credit mix — i.e. the types of accounts you have (10%)

FICO Score: Your FICO score can range from a low of 300 to a high of 850. To achieve a score of 850 indicates you are among the most trustworthy of all borrowers, but most Americans do not have a credit score that high. According to most studies, the average credit score is between 650-700. WisePiggy, for one, gives you the ability to check your credit score instantly and free.

FICO is not the only credit scoring model. Another one used in credit decisions is the Vantage 3.0, which now uses the same credit scoring range as FICO, the 300-850 scale range. Vantage 3.0 is sometimes seen as a scoring model that can be more friendly to consumers with thin credit or who are rebuilding their credit. Like FICO you can see your Vantage score through the major credit reporting bureaus TransUnion, Equifax, and Experian.

Credit utilization is an important part of your credit score. Carrying high balances compared to your total credit limit can damage your credit score. Say, for example, you have a total credit limit of $30,000 on all your credit cards, but currently, carry a $25,000 balance from month-to-month across all these cards. A lender likely will view you as a risky borrower because you use more than 83% of your available credit and aren’t able to pay off most or all of your balances each month.

Credit limit refers to the maximum amount you can borrow. Lenders and credit card companies determine your credit limit based on your credit score and overall creditworthiness. Borrowers with a good credit score (at least 700 on an 850 scale) are usually approved for a higher credit limit than those with lower credit scores because lenders view the latter group as riskier.

Other Credit Score Factors: Some types of debt — like high-interest credit card debt — hurt your score more than others. Missing payments because you can’t afford your debt also isn’t good for your credit, since your payment history accounts for 35% of your score. To improve your credit, pay your bills on time, catch up on missed payments, keep your balances low — or better yet — pay off your balances in full each month. Also, be prudent about borrowing. Read the fine print before you agree to a loan and pay careful attention to interest rates. If you’re working to rebuild your credit, credit counseling can help you get back on track financially. If you’ve ever wondered why different credit reporting bureaus show different credit scores, it largely comes down to the information they have on file and each bureau might have slightly different information. The key thing is to review your credit information every year and correct any mistakes.

Debt-to-income ratio (DTI) is the amount of monthly debt you have as a percentage of your income. Next, to your credit score, DTI is one of the most important metrics lenders use to determine your creditworthiness. Most lenders view borrowers with a DTI of 36% (or lower) favorably. Those with a DTI above 43% will have more trouble borrowing money or getting lower interest rates. Overall, a good DTI can lower the cost of a loan for borrowers who do not carry high balances or a lot of outstanding debt from month-to-month.

Balances and Credit Score: Your current debts account for 30% of your credit score. Carrying high balances from month-to-month can harm your credit, make you more risky to lenders and subject you to higher interest rates when you need to borrow. Try to pay off balances in full every month — or better yet, only charge what you can afford.

Debt Management Terminology

Eighty percent of Americans have debt, but unfortunately just as many aren’t financially literate. To help you become more knowledgeable about managing your debt, here are some key terms every borrower should understand.

Repayment refers to paying back the amount borrowed from a lender. This amount includes both principal (the original amount borrowed) plus interest. Debt is repaid in monthly installments over a specified term, such as a 5-year personal loan or 15-year home mortgage loan. However, some borrowers can pay off the debt in one lump sum payment, which helps them save on interest.

Balance transfer is when you take the amount owed to one lender and transfer it to another. Credit cards are the most popular vehicle for balance transfers. Consumers often do a balance transfer to take advantage of a lower interest rate or APR. For example, you may transfer a balance from a credit card with a 29.99% APR to one with a 0% introductory APR for 12 months, which means you pay no interest for a year. Some credit cards come with a 3% to 5% balance transfer fee, meaning you’ll be charged a fee based on the percentage of your transferred debt. Let’s say you transfer a $1,000 balance to a credit card with a 3% balance transfer fee, you’ll end up paying a $30 fee for the privilege.

Annual fee is an amount a credit card company charges you to use its credit card. It is charged once a year to your credit card and usually ranges from $0 to upward of $95. To attract new cardmembers, some credit cards offer an introductory $0 annual fee for the first year, while others — like many cashback cards —don’t have an annual fee at all. Unsecured credit cards that don’t offer perks or rewards usually don’t have an annual fee, while travel rewards, airline miles, and secured cards do.

Collateral is an asset, such as a car, home or other personal property, that a borrower will put up to secure a loan. Secured loans require collateral because this gives a lender other options to recoup borrowed money in the event a borrower defaults on his or her loan. Lenders can seize a borrower’s personal assets if the person does not pay back the loan. Because collateral helps guarantee the amount borrowed, secured loans usually have lower interest rates than unsecured loans, which don’t require collateral for borrowing.

Minimum payment is the lowest amount borrowers are required to pay on their debt each month. Credit cards, student loans, personal and mortgage loans all have minimum monthly payments, which are outlined in the loan terms. The minimum payment is a percentage of the balanced owed. Failure to pay it can result in late fees and additional charges and hurt your credit score.

Prepayment penalty is an additional payment to a lender or financial institution if you pay off your loan balance earlier than the end of the loan term. Some lenders may stipulate that a borrower can’t pay off more than a certain percentage of their loan balance in a given year. Most mortgage companies, for example, set this threshold at 20 percent a year.

The advantage of prepayment for borrowers is that they pay less interest on their loan. But since lenders make their money off interest, they devised a prepayment penalty to discourage borrowers from paying early. However, due to changes in federal law after the 2007-2008 mortgage crisis, prepayment penalties are no longer allowed on most mortgage loans except for certain types of qualified mortgages.

Principal is the amount you borrow or still owe on a loan. For example, the principal on a $300,000, 30-year fixed rate loan would be $300,000. The principal is distinct from interest, but lenders calculate the overall balance you owe by combining these two numbers.

Interest is the cost of borrowing money. Lenders apply interest to the original amount you borrow (principal). Interest rates come in two forms: variable, which changes based on market conditions or fixed, which remains the same over the life of the loan.

Difference Between Good and Bad Debt

Debt isn’t always a four-letter word. When used strategically, it can help you increase your income and overall net worth. In consumer credit, there’s good debt and bad debt. Here’s the difference.

Good debt involves purchases that help a borrower invest in his or her future. Mortgage loans, student loans and business loans are all examples of good debt because they create long-term value, helping a person further his or her education (which correlates to higher income) and giving someone the means to start a business or buy a home that will likely increase in value.

Bad debt involves purchases that depreciate in value, including a car loan and credit card debt. Cars lose their value the moment you put any mileage on them, so taking out a loan to make this purchase isn’t as sound an investment as a student or mortgage loan. Clothing, shoes, furniture, and vacations also don’t retain their value after use. Swiping your credit card and going into debt to purchase these items isn’t the best financial decision either. Credit card debt also is considered bad debt because it’s high interest. Current debts account for 30% of your credit score, so carrying high credit card balances can affect your creditworthiness long term.

Consolidation of Debt

If you are struggling to get out of debt, there are several options to help you lower your monthly payments and improve your finances:

Debt Consolidation: Debt consolidation is a form of debt refinancing that involves combining all your high-interest debt into one loan at a lower interest rate. By consolidating your debt, you streamline the repayment process because you only have to pay one bill instead of several bills to different creditors. Another advantage is that lower interest rate of a consolidated loan helps you lower your interest expense long term, potentially saving you hundreds — if not, thousands — of dollars.

Balance transfer credit cards allow you to move an existing balance from a high-interest rate credit card to one with a lower interest rate. Many balance transfer cards have introductory offers such as 0% APR for 12 or 18 months and some even waive the 3% to 5% balance transfer fee they charge to transfer your debt. Balance transfer credit cards are a good debt consolidation option if take advantage of the zero interest benefit and pay off your balance during the introductory period.

Cash Out Refinancing: Similar to a home equity loan or line of credit, cash-out refinancing requires borrowers to secure the loan with their home. For homeowners who need cash to finance a major expense or pay off high-interest debt, cash-out refinancing is a viable option because your home’s equity is paid to you in cash. However, if you default on the loan, you could face foreclosure because your home is used as collateral to secure this financing.

Home Equity Line of Credit (HELOC): Borrowers can use home equity financing in two ways: as a loan or line of credit. A home equity loan uses your property to secure the loan, resulting in a lower interest rate than an unsecured loan. It is a set amount that a borrower pays back in monthly installments over a specific time period. Consumers are typically allowed to borrow up to 85 percent of the equity (the difference between what you owe and the current market value) of their home. A home equity line of credit (HELOC) is a revolving credit line that allows homeowners to withdraw money out of their home equity. Like a credit card, HELOCs allow you to borrow money when you need it. Homeowners can access the funds via check or a credit card connected to their HELOC account. Like a home equity loan, your home is used as collateral. It’s important to understand that while home equity loans and HELOCs allow you to borrow money at lower interest rates, they also come with certain risks: they reduce your home’s equity and put a lien against it that may lead to a foreclosure if you can’t make payments.

Personal Loan Consolidation: Consolidate unsecured debt (credit cards) into a single loan with one monthly payment. Personal loans usually have fixed interest rates and require that borrowers repay the loan, plus interest, in monthly installments. Interest rates on personal loans can range from 5% to 36% depending on the borrower’s credit history. See the most current rates on personal loans, plus unbiased reviews.

Student Loan Consolidation: Combine various student loans into one loan to take advantage of a lower interest rate. Student loan consolidation has several benefits, including reducing your long-term interest expense over the life of the loan and more streamlined debt management because you only have to pay one loan instead of multiple loans.