Different Types of Consumer Credit Explanation: Hints on Borrowing Smart
Updated: Aug 18, 2020
Debt in America is sadly just a way of life for most people these days. According to the most recent data, 80% of American adults are trapped up in the cycle of debt. That’s right, go grab five random people that you know, and probably only one of them is not indebted to multiple different companies.
Before we get started, we need to get this out of the way early on: debt is not necessarily a bad thing. Without the option to go into debt, hardly anybody would be able to buy a house, go get a car, or attend college. Debt allows us to have things we need right now in the present, and pay them off sometime in the future.
With that out of the way, there are many forms of debt that have well-deserved negative connotations associated with them, such as high-interest credit cards. Or, the predatory practice of payday loans. Just because those don’t go on your credit report doesn’t mean they’re not a terrible form of debt.
There are good forms of debt that people abuse and get them into a bad hole. A good example of this would be using the equity in your home to live outside of your means. Tapping into the equity in your home is a good way to get a low-interest loan for a major purchase. It can turn negative whenever someone decides they want to take out a second mortgage to get a new car that they don’t need and then go on a lavish vacation around the world.
What Are The Different Types Of Consumer Debt?
Americans have been fighting debt for a while now. Over time, debt-collection practices have become more and more aggressive. Because of this, the U.S. government had to enact the Fair Debt Collection Practices Act (FDCPA) which primarily sets rules on how debt can be collected, but also defines what constitutes consumer debt.
According to the FDCPA, consumer debt is any type of debt that is personal in nature (ex: if you own a business and have a back-up payroll line of credit that you have to tap into, that isn’t consumer debt.) In addition to being personal in nature, it is also primarily debt that was incurred for other ‘personal, family, or household purposes.’
The most common forms of consumer debt are:
● Credit Cards
● Student Loans
● Car Loans
● Payday Loans
Other forms of consumer debt that often get overlooked may be something as simple as a cell phone bill or utility bills.
Even if you overdraft your bank account the amount that you owe them can be classified as consumer debt.
Simply put, if you enter into an agreement with some kind of merchant, and you owe them money, it’s probably considered consumer debt in some form or another.
If you enter into an agreement with an attorney to settle some of your legal issues, then the bill to your attorney is considered consumer debt.
Voluntary vs. Involuntary Debt
Consumer debt must be voluntary. If you owe taxes to the IRS, that is not counted as student debt as it is not voluntarily. On a similar note, if you owe medical bills then that likely isn’t consumer debt as well, assuming you didn’t voluntarily have a heart attack or voluntarily break your arm.
Consumer Debt In America
Almost 92% of consumer debt in America can be broken down into four main categories: credit card debt, student loans, auto loans, and home mortgages. These four main areas of consumer debt see consistent rises year after year.
Credit Card Debt - Back in 2008, just after the housing market crash, credit card debt accounted for over 38% of all consumer debt in America. These days that number is just a little bit above 26%. It’s still a tremendously high number, but much better than it was over a decade ago. Most of the credit card debt that Americans carry is from unexpected medical bills or health-related expenses.
Student Loans - The total amount of student loan debt sits at around $1.78 Trillion. In 2010 the government booted Sallie Mae out of handling student loans and took control of it themselves. As part of the changes, a wider group of applicants were eligible for loans which caused an explosion in the student loans market.
Home Mortgages - Well over $9 Trillion in American consumer debt can be attributed to home mortgages. If utilized properly, a home mortgage debt should not be seen as something bad or negative. Mortgage debt has been on the increase since 2013 which is a good thing as it means the housing market is growing and more and more Americans are able to afford their own home these days.
Auto Loans - About $1.3 Trillion in consumer debt is from auto loans. After the 2008 recession, the government drastically lowered interest rates which caused a boom in new car sales. Even though many of these were just 3-5 year loans, the momentum has kept it’s pace and is still growing to this very day.
Consumer Debt: Let’s dig a little deeper.
As we coasted through 2019, many Americans were barely keeping their heads above water when it came to fulfilling their debt obligations. When 2020 started rolling through and Covid19 started picking up steam, many Americans were now officially drowning in debt. A vast majority of Americans were usually just one or two missed paychecks away from getting themselves into a very tight spot.
According to the most recent data available (as of May 2020), Americans have a total of $4.144 Trillion in consumer debt. The average consumer debt per capita in America is $12,687. Almost 75% of this debt is what’s known as revolving debt.
Revolving debt is debt that you can pay off and then borrow again from that same source. The best example of this would be a credit card. You use your credit card to charge something (aka borrow money). You then pay your bill off. Next, you charge the card again (borrow more money). This is a revolving cycle. A line of credit is another good example.
Installment debt is debt that gets repaid in set monthly payments. You borrow the debt, you pay it off, and that’s it. This can be your car loan, your mortgage, or even a payday loan.
Pros & Cons Of Consumer Debt
As a whole, incurring consumer debt obviously isn’t the most ideal situation. Of course we would love to be able to just buy a house outright without taking on a mortgage that we may be paying on for 25 or even 30 years. Credit card debt is terrible because the interest rates are ridiculous. Payday loans are the absolute worst with annual percentage rates that factor out to be between 300%-500%.
On top of that, the reasons we go into debt aren’t always for necessary reasons. Sure you’ve got that credit card with a 5-figure limit, and sure if an emergency comes up you would be prepared, but how often have you purchased something on that card and ended up paying way more in the long run while paying the bill down?
Conversely, consumer debt encourages consumer spending which keeps the economy turning. This process achieves what economists call Smoothing of Consumption. A simplified version of this is how early on in life we borrow a lot of money. Money for an education, money for a home, money for our first car, money that essentially invests in our future. As we grow older we are able to chip away at the debt more and more.
And speaking of consumer debt for an education, that is often viewed as a step forward in the right direction. Or, as economists put it, an upward trajectory move to make. You have to borrow the money to get your education so you can graduate college and make more money as an adult. This is good for both you and the economy.
If your debt isn’t properly managed early on then you will, without a doubt, have some sort of hindrance with borrowing money or having credit extended in the future. You may be denied for a loan that you so desperately need. Or, you may be approved for that loan but with a high interest rate that can cost you thousands of dollars more over time.
Consumer Debt & Chapter 7 Bankruptcy
Many consumers seek relief from their debt by filing bankruptcy. The reasons behind doing so are wildly different. Maybe you got in over your head by going on too many shopping sprees. Maybe you lost your job and simply can’t keep up with the payments. 580,000 Americans last year filed bankruptcy because they had too much medical debt.
Whenever you file bankruptcy, you are essentially relieved of your debt obligations with a few possible caveats. There are a couple of different forms of bankruptcy. A Chapter 13, for example, helps to reorganize your debts in a way that you can make limited payments to satisfy creditors.
If you have the means to pay back some of the debt, even if it’s not much, you will likely only qualify for a Chapter 13 bankruptcy which simply restructures everything. Simply filing for bankruptcy won’t just make everything magically disappear, unless the courts have found that you simply have no way to pay it back. In which case you may qualify for a Chapter 7 bankruptcy.
A Chapter 7 bankruptcy is meant for people with little-to-no income who need relief from all of their consumer debt obligations. A big factor in this is that whomever is the trustee of your filing may choose to liquidate your assets in order to pay off your creditors. This type of bankruptcy is mostly used for unsecured debt (debt that isn't backed by a collateral) like credit card debt and medical bills.
What kind of debt qualifies for Chapter 7 relief? Almost all unsecured debts can be relieved with a Chapter 7 bankruptcy filing. An unsecured debt is something not backed by collateral. Common forms of unsecured debt that can be discharged include medical bills, credit card bills, utility bills, student loans, and even past-due rent.
Why can’t secured debt be discharged in Chapter 7? Whenever you purchase a home, or a car, you make an agreement with a creditor that those items are to guarantee the loan gets repaid. Should you not pay these loans your creditor is able to come foreclose on your house or repossess your car. Rather than discharging this debt in bankruptcy, the creditors could just come and collect their collateral back.
Some secured debt can be discharged, sometimes! Not all secured debt is exempt from Chapter 7 relief. Sometimes you may actually qualify to have a secured debt discharged but the creditor is allowed to come after their collateral. Normally, if you get your car repossessed, you still owe that loan. If you got a car loan discharged you would lose the car, but wouldn’t owe on the loan anymore.
What kind of unsecured debts cannot be discharged in Chapter 7 bankruptcy? There are numerous forms of unsecured debt that you are not allowed to get relief from, even during Chapter 7 bankruptcy proceedings. These include (but aren’t limited to):
Student Loans - It’s uncommon for student loans to be discharged through Chapter 7 bankruptcy unless you can somehow prove that even in the distant future you won’t be able to pay them off.
Fraudulently Accrued Debt - If you went into a bank to apply for a loan and lied about your income to guarantee an approval, that loan would not be eligible for relief from Chapter 7 bankruptcy.
Some Luxury Purchases - If you make a luxury purchase of $750 or more within 90 days of filing for bankruptcy it likely won’t be discharged.
Cash Advances - If you take any cash advances from any credit cards or lines of credit of $1,000 or more within 70 days of filing for bankruptcy, that too likely won’t be discharged.
Certain Tax Debts - Some tax debts incurred within two years of you filing, or tax debts owed as a result of false or fraudulent pretenses cannot be discharged.
4 Smart Financial Lending & Money Borrowing Strategies
Now, we’ve probably spent a bulk of your time reading this article making you fearful of debt. While that’s not necessarily a bad thing, sometimes we really do just need to borrow money. But how should you go about doing it properly? You don’t want to end up part of the consumer debt statistics in a negative way, right? Here’s our best tips for those that need to borrow money or have credit extended to them.
1. Shop Around Different Loan & Credit Products
There are different loans for different things. Choosing the wrong loan for the wrong purpose can cost you a lot more in the long run. Shop around online and look at the different types of loans available. For example: You wouldn’t take out a $10,000 personal loan to consolidate debt if you had equity in your home available. The interest rates would be vastly different.
When consolidating debt, make sure you go with an option that has lower interest rates than what you’re paying now. It defeats the purpose when you end up paying more in the long run. Many credit card companies offer 0-balance transfer options where they will take on your old credit card debt and not charge you any interest for a year.
2. Check Your Credit Score
It’s important to know what your credit looks like before you apply for a loan. You may end up wasting your time with one lender or having unnecessary pulls on your credit, which can affect you negatively. Annualcreditreport.com is a free website run by the U.S. government that lets all Americans check their credit history once a year for free.
Not only will this give you an idea of your credit score, but it will give you a chance to look through your credit history and see if anything is out of the ordinary. Are there any late payments listed despite the fact that you always pay on time? Is there an account on there that you know you never opened? Dispute these inaccuracies before you go out and apply.
3. Read The Fine Print & Ask Questions
There is a lot that goes on behind the scenes of banks, credit unions, and other financial institutions. Some of them plan on getting as much interest out of possible and, as a result, will charge you a prepayment penalty if you try to pay your loan off early.
Additionally, some of them will actually give you discounts if you sign up for some sort of deposit account with them, or agree to have your monthly payment automatically debited from your account.
It doesn’t hurt to also double check that the lender will report to the three major credit bureaus. If you’re going to be paying them back on time, you want to make sure it improves your credit score and looks good in your credit history over time.
4. Keep Realistic Expectations
Long gone are the days where loan officers will take a subjective approach to loan approvals. These days it’s much more automated. They will primarily review your credit score or credit history, and then take a look at your debt-to-income ratio.
Furthermore, the loan process or the process of extending credit can take time, especially if collateral is involved. It’s not wise to rush to the bank in an emergency and expect to walk out with thousands of dollars. Set realistic expectations and don’t get your hopes up.
Consumer Debt Help: Improve Your Credit & Pay Off Debt
If possible, it’s always good to improve your credit and get your debt paid off before applying for a loan or a credit card. Even if you know your credit is good enough to get an approval, a better credit score could possibly land you a much lower interest rate. A few percentage points can mean a difference of thousands of dollars.
The single best way to improve your credit is to start tackling the debt that you already owe. There are a few ways to go about doing this, some are better for certain people than others, but all are better than having no plan of action at all.
Debt Snowball - With the debt snowball method you pay the minimum monthly payments on all of your debt except the smallest obligation that you’ve got. Pay as much as you can on the smallest debt. Once it’s paid off, take what you were paying on that one and apply that much with the same minimum payment as before on the second smallest debt. Once that one’s paid off go to the next debt in line. And so on and so on until your debt payments have snowballed into being so big that your obligations are quickly met.
Debt Avalanche - Similar to the debt snowball, the debt avalanche involves paying off the debt with the highest interest rate first, and making minimum payments on everything else. Once the debt with the highest interest is paid off, you move on to the second highest. This method takes more time than the debt snowball but, because you’re paying off higher interest rates first, often can save you more money in the long run.
Debt Snowflake - With the debt snowflake method you look for tiny little ways throughout your daily routine to save money. You apply those tiny savings to your debt. For example, if you get a large coffee every single morning, consider switching to a medium-sized coffee. If the difference in size saves you $1.25 every morning, you now have $456 extra each year to go towards debt. Find a few small ‘snowflakes’ throughout your day and you’ll have thousands of dollars extra to go towards paying off your debt.
Credit Counseling - The final tip we want to leave you with today is that credit counseling services exist for those that are in over their head and just don’t know who to turn to. In fact, many non-profit credit counseling services exist for the sole purpose of helping consumers alleviate their debt. If you feel trapped and aren’t sure what your next move should be, consider giving them a call for help from a certified financial professional.
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