Debt meaning – what different types of debt are there and how can you minimise it?

Thankfully at school, we were taught algebra and the equation of pie, which obviously helped us in heaps and bounds when we burst into the real world and came face to face with our first big debt – student loans. Student loans are usually the first introduction to debt, either that or a car finance for young adults, but did you know debt has different meanings?

In today's fast-paced world, financial stability is a top priority for millennials. While dreams of adventure, homeownership, and pursuing higher education drive us forward, understanding the nuances of debt is a skill we need to master, and sharpish. Debt can be both a friend and foe, depending on your debt management plan. In this comprehensive guide, we will delve into the world of debt, uncovering its various forms, from credit cards to mortgages, and explore how millennials can wield it to their advantage while avoiding its pitfalls.

Debt meaning – firstly, what is it?

Debt, in simple terms, is the money you owe to someone else. It's like borrowing from your future earnings to fund your current needs or desires, as you will always have to pay it back. While it can offer the opportunity to access resources you might not have upfront, it also comes with the responsibility of repaying that borrowed sum along with an added cost, known as interest, in monthly payments.

Debt can be categorised into two main types: secured and unsecured. Secured debt is backed by collateral, which serves as a guarantee for the lender. Common examples include mortgages and car loans. Unsecured debt, on the other hand, lacks collateral and typically has higher interest rates. Credit cards, personal loans, and student loans are examples of unsecured debt.

Let’s go through the multiple types of debt and how we can manage it in our lives by building a strong debt management plan.

Credit cards

Credit cards have become a staple in the lives of millennials, offering convenience and purchasing power. They are a form of unsecured debt, allowing you to borrow up to a certain credit limit. However, if not managed wisely, credit card debt can snowball quickly due to high-interest rates.

As credit cards are not a ‘secured’ loan, the interest rates are typically higher. This is because the bank is letting you borrow money with no back up plan, so it’s taking more of a chance on you, this chance comes at a higher price.

Credit cards can be a tool you can put to your advantage, as long as you’re disciplined with it. I’ve talked before about the advantages of using a credit card, but the minimum requirement in my book is you absolutely have to pay it off in full every single month. If you can treat it like a debit card, not over-indulge and pay it back in full every month, you can avoid interest charges (many cards offer interest free rates for a limited amount of time), late payment fees and enjoy benefits such as points, cash back, air miles and more.

Check out my ultimate guide to the different types of credit cards you can get here.

Personal loans

Personal loans are versatile tools that can be used for a variety of purposes, from consolidating existing debt to funding a dream vacation. These loans are usually unsecured, meaning no collateral is required. Their fixed interest rates and structured repayment plans make them a fairly good option for managing debt.

Personal loans are popular for a few reasons, firstly, their fixed interest rates and structured repayment plans make them a fairly good option for managing debt. Secondly, personal loans can be taken out for most things apart from gambling, or the lease or purchase of property, and of course, anything illegal. This means you can get the money for your specific needs or financial goals.

Student loans

The pursuit of higher education often comes with the burden of student loans, and yes my friends it’s got worse for the younger millennials and Gen Z. University fees are sky high right now, it’s no wonder many are choosing to move away from higher education. I had the best time of my life in University and I do believe I wouldn’t have kicked off my career like I had without my degree, but on the flip side, I am still paying off the student debt.

Student loans are typically made out of two elements - a loan for tuition fee, and a maintenance loan. The tuition covers your academic course, while the maintenance helps you towards accommodation, books, food, etc.

These loans can be a stepping stone to future success but require careful consideration. The important thing to know about student loans is that you start getting charged interest from the day you take it out. In the UK, you only start repaying the loan when you earn over a certain income, and it’s automatically deducted from your payslip.

Interest rates vary across the UK, in England and Wales it’s based on the retail price index (RPI) measure of inflation, plus 3 percent. It’s capped at 7.3% from September 2023. In Scotland and Northern Ireland it’s 6%.

Mortgages

For many millennials, homeownership is a cherished goal, and mortgages are the thing of nightmares but, welcome to adulting. Mortgages, a type of secured debt, provide a means to make the homeowner dream a reality. The property itself serves as collateral, reducing the lender's risk. Fixed-rate mortgages offer predictability, while adjustable-rate mortgages may provide lower initial rates but carry more risk.

What’s the difference between fixed and variable rates I hear you ask?

The ‘rates’ are interest rates set by the Monetary Policy Committee. This is the committee that is committed to keeping inflation low within the UK. If your mortgage is a ‘variable rate’ it means the interest rate will change when the MPC changes the rates for the UK – this could make your mortgage payments go up or down depending on how the economy is doing. If your mortgage rate is ‘fixed’, it means it’s fixed at a rate that was provided at the time of taking it out, and will not change even if the MPC interest rate changes, for the duration of your fixed term, meaning your mortgage payments will remain the same.

So for example, you could take out a fixed rate mortgage at 3.4% for 5 years, over a 20 year term. This means, for the next five years you will pay an interest rate of 3.4%, after those 5 years are up and when you still have 15 years left of paying, your rate switches to variable, or you can remortgage and get another fixed term. (I always recommend the second option).

Car finance

Car loans, also known as auto loans, fall under the category of secured debt. Just like mortgages, the car itself acts as collateral. It's important to consider both the interest rate and the total cost of the loan when financing a vehicle. You should work out how much extra cash you will be spending when the vehicle is fully paid off, as it usually adds quite a bit to the overall cost. If you don’t pay the vehicle off in full throughout the duration of your finance, double check you have the choice to hand the car back, as sometimes you are required to pay the remainder in full at the expiration of your contract. Always read the fine print.

Overdrafts

An overdraft allows you to spend more money than you have in your bank account, essentially borrowing from your bank for a short period of time. While convenient, overdrafts often come with high fees, making them a costly way to manage cash flow.

There are also two types of overdrafts - planned and unplanned.

Planned, as you can probably guess, is an overdraft agreed upon with your bank beforehand, unplanned is when the bank allows money you don’t have to come out of your account when you purchase something, and creates an overdraft. In the past, banks charged a higher interest rate for unplanned overdrafts, however since 2020 they are no longer allowed to do this.

All overdrafts are charged with an annual rate fee.

Debt as a tool: Can it work for you?

Debt can be an empowering tool that can be used to achieve your goals, but it requires careful planning and execution. Used wisely, debt can help build credit history, fund education, or secure a home. However, before taking on debt, it's crucial to assess your financial situation, determine your ability to repay, and explore alternative options.

Not all debt is bad, having good debt management habits can help you make debt work for you, for example, owning a credit card and paying it back in full will boost your credit score. Paying loans back on time will also help your score, meaning you become a more preferable borrower to the banks. This is especially useful when it comes to bigger purchases such as buying your first home. You may have heard of the term ‘no credit history is as bad as a poor credit history’, and this is unfortunately true. If you have no evidence of repaying money owed to you when it comes to taking out a mortgage, you may struggle to be approved.

The reason being, the creditors have no information to go on regarding how likely you are to repay the funds they are loaning you. It’s a catch 22, but managed sensibly, debt can work for you.

Mastering debt management: How to minimise your debt

Minimising debt is a key step in achieving financial freedom. Here are some strategies to help you navigate the debt landscape with confidence:

Budgeting: Create a detailed budget that outlines your income, expenses, and debt repayment goals. Stick to this budget to avoid overspending. Read my blog on how to budget money. Remember, always make timely payments on your debt repayments.
Emergency fund: Establish an emergency fund to cover unexpected expenses, reducing the need to rely on credit cards or loans. This is usually 6 months expenses saved in a separate account, by having this, it protects you from any twists and turns life throws at you and leaves you less likely to need to delve into further debt to pay off any unexpected costs. Our how to build an emergency fund blog can help you get started.
Prioritise high-interest debt: If you have multiple debts, focus on paying off high-interest ones first to save on interest payments in the long run. Don't forget to meet at least the minimum payments of your other debts so you don't fall foul to late fees.
Debt consolidation: Consider consolidating high-interest debts into a single loan with a lower interest rate, simplifying repayment. Banks, instalment loan lenders and credit unions can offer loans that consolidate debt, you then only have to make the one repayment. This is a popular debt solution but depends on how much debt you have. Always talk to a debt adviser before settling on this as a debt solution.
Extra payments: Whenever possible, make extra payments towards your debts to accelerate the repayment process and reduce the overall interest you end up paying.
Financial education: Continuously educate yourself about personal finance to make informed decisions and avoid falling into debt traps, in other words, keep reading this blog! :)

Debt is a multifaceted aspect of modern financial life that demands careful consideration. As millennials, we have the power to leverage debt to achieve our goals while minimising its negative impact.

By understanding the various types of debt, its potential benefits, and the strategies for managing it effectively, we can pave the way toward a brighter financial future, one that empowers us to chase our dreams without sacrificing our long-term stability.

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