What Is Consumer Debt, and Why Does it Matter?

Debt is a part of life for many Americans, whether you have a rewards credit card to score freebies or a mortgage to pay for your dream house. But not all debt is created equal.

You’ve likely heard the term “consumer debt” here and there. But what is consumer debt, and how does it differ from other types of debt? We cover this and more below.

What is consumer debt?

Consumer debt is any debt used to purchase goods or services for personal consumption. For example, if you take out an auto loan to buy a vehicle, that loan is consumer debt.

In return for the funds you borrowed to pay for your goods and services, consumer debt lenders charge an interest rate or annual percentage rate (APR). Some interest rates are fixed from the day you officially sign for the loan, and others have variable interest rates that change periodically.

Consumer debt is different from business debt, which would be any debt you incur for use in a business or organization.

What are some examples of consumer debt?

There are countless examples of consumer debt in today’s world. Here are some common examples of personal debt we encounter almost daily.

Credit cards

Look in your wallet — you’ll likely see one of the nation’s leading consumer debt instruments. A credit card is a revolving consumer credit, which means you can use it repeatedly if you have some unused credit limit.

For the most part, credit card debt is also unsecured, meaning there is no asset protecting the credit card issuer. So, if you default on the payment, the credit card issuer has no direct rights to your property to recoup its losses. The issuer could technically sue you and receive a judgment requiring you to liquidate assets to repay the credit card balance, but this is uncommon.

Some secured credit cards exist and require a security deposit in the amount of your credit limit. So, if you max out a secured credit card, the credit card company can keep your security deposit as payment for the outstanding balance.

Credit cards generally have a variable interest rate, which will fluctuate. The variable interest rate will shift along with the federal funds rate set by the Federal Reserve. So, as it increases or decreases, your variable interest rate will also rise and fall.

Auto loans

Another common type of consumer debt is likely attached to the car parked in your garage: an auto loan. The average price consumers pay for a new car is more than $48,000, and few people have that kind of cash lying around. So, we tend to use car loans to fill the gaps in purchasing cars.

An auto loan is a secured debt, meaning it has an asset that protects the lender from a total loss if you default on the loan. The asset is almost always the vehicle you purchased with the loan. So, if you default on the loan, the lender has the right to repossess the vehicle and liquidate it to recoup its losses.

A car loan is an installment debt because you can only use the loan once to purchase the vehicle, and you make fixed monthly payments for a set number of months — known as installment payments — until you pay off the loan.

The interest on an auto loan is typically fixed, meaning it does not fluctuate with the federal funds rate. However, it’s not entirely unheard of to see variable-rate auto loans. In addition, some auto loans have balloon payments. This means you get a lower payment for most of the loan term, but there’s one large balloon payment at the end of the loan.

Typically, an auto loan will require an initial down payment, though there are 0% down options for those with good credit scores.

Mortgages

A home loan, also called a mortgage, is another common type of household debt. Like a new car, real estate would typically be out of reach for most people if we didn’t have mortgages.

A mortgage is a secured debt that generally uses your home as collateral. So, if you default on the mortgage, the lender can foreclose on your home and sell it to recoup its losses.

A home loan is an installment debt because you can only use the loan once and make monthly payments on a fixed schedule until you pay off the loan.

Most of today’s home loans are fixed-rate, meaning the interest rate is set at the beginning of the loan and does not change unless you refinance it. 

However, adjustable rate mortgages (ARMs) offer a lower initial interest rate than fixed-rate loans. Still, the interest rate periodically adjusts along with the federal funds rate and can eventually be higher than a fixed-rate loan.

Like an auto loan, a home mortgage requires a down payment for approval, though some special government-backed programs require 0% down.

Another type of mortgage debt is a home equity loan, which uses the equity in your house — the home’s value minus what you owe on your original mortgage — to secure a second mortgage. Like traditional mortgages, home equity loans are typically fixed, but adjustable-rate home equity loans are available.

Student loans

Completing a bachelor’s degree can cost more than $200,000, so paying cash is often out of the question. This is where student loans can help. Two types of student loans exist, federal and private. 

Federal student loans are offered through the government via select loan servicers. 

Private lenders offer private student loans. They have no federal government backing and lack the additional benefits of federal student loans, such as lower interest rates, forbearance options, income-driven repayment plans and student loan forgiveness options.

Student loan debt is typically unsecured installment credit because there’s no collateral securing them, and you make payments for a fixed term until you pay the debt in full.

Federal student loans have fixed interest rates, and private student loans can have a fixed or variable interest rate that fluctuates with the federal funds rate.

Personal loans

Personal loans are another type of consumer debt. They’re typically unsecured installment loans that the borrower can use how they please, though some have prescribed purposes, such as debt consolidation loans.

Personal loans come in many shapes and sizes. They can be fixed- or variable-rate and the lender will often wire the funds directly to your bank account so that you have the cash quickly and can spend it as you please. One exception is a debt consolidation loan, as some lenders may require you to allow it to pay off your lenders directly.

Payday loans

Payday loans give you access to fast cash between paydays to cover expenses. They’re an installment debt, and you repay the loan in full on your next payday. You must pre-authorize the repayment via debit card or a post-dated check to the lender in many cases.

For example, if you have over a week until you get paid, and your car breaks down, you can visit a payday loan provider for the cash needed to pay the repair bill. On top of repaying the loan, you’ll also pay interest and other fees that can lead to an astronomical APR.

Payday loans are often unsecured, though you preauthorize the repayment because there’s no asset the lender can repossess if your repayment fails. And they typically have a fixed interest rate.

Why do you need to understand consumer debt?

Consumer debt can significantly impact your personal finances and the security of your financial future. Let’s look at why it’s important to understand and properly manage consumer debt.

It affects your credit score

Almost all consumer debt — except payday loans — appears on your credit report and can impact your credit score in multiple ways.

The most significant impact on your credit score is your payment history, which accounts for 35% of your FICO credit score. If you improperly manage your consumer debt and are 30 days or more late on a payment, the creditor could report the late payment to all three credit bureaus, potentially causing your credit score to drop.

Another significant factor in your FICO credit score is the amounts owed, which accounts for 30% of your score. A big part of this variable is your credit utilization ratio, which is your total debt balances relative to your credit limits on your revolving credit accounts. So, if you have a combined $10,000 in credit limits and $5,000 in combined revolving debt, you’d have a 50% credit utilization ratio.

As you run up revolving debt, your credit utilization ratio increases, negatively impacting the amounts owed variable. This can lead to decreases in your credit score.

On the flip side, if you manage your consumer debt properly with on-time payments and a low credit utilization ratio, you can build a strong credit score and receive additional credit, such as mortgages and auto loans, more easily.

It can impact your ability to save

The goal of saving for retirement is important in many people’s lives, and consumer debt can make this difficult. If you have too much consumer debt, you may have limited disposable income to invest in your retirement, slowing the pace at which you build wealth.

Also, high-interest consumer debt, like credit card debt, offsets much of the interest you earn on your retirement savings.

It can cost a lot in the long run

Some consumer debt, such as credit card debt, can have interest rates in the high teens and low twenties. This can add to significant interest charges, especially if you only make the minimum payment.

Many credit cards’ minimum monthly payments are only a small percentage of the principal balance plus your interest charges, such as 1% of your balance plus accrued interest. So, if you have $10,000 in debt on a 19% APR credit card, you’d pay only $100 toward your balance and another $158.33 in interest.

This would take 28.5 years to pay off and cost you $14,423.16 in interest if you made only the minimum monthly payments, according to Bankrate’s minimum payment calculator.

Understanding what consumer debt is can help secure your finances

Understanding what consumer debt is and how to manage it can go a long way in helping secure your finances. While too much debt can be difficult to manage, the right amount of well-managed consumer debt can help you secure larger items, like a car, or those that will eventually be valuable assets, such as a home.

Is credit card debt and other revolving debt standing in the way of sound personal finances? The Tally† credit card debt repayment app can help. Tally helps you manage your credit card payments and offers a lower-interest line of personal credit, allowing you to pay off higher-interest credit cards more efficiently. 

†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.