What is debt?
Debt is something (usually money) borrowed by one party from another. Debt is used by both individuals and businesses to make purchases they couldn’t otherwise afford, and gives them permission to borrow money under the condition it is paid back at a later date. Debt agreements usually come with added interest, meaning the person borrowing money will end up paying back more than what they borrowed.
Interest: Interest is what the bank or lender will charge you for the privilege of borrowing money from them. It’s typically charged as an annual percentage rate (APR).
Why is debt a problem?
Debt can be a problem because it’s easy to get into but difficult to get out of. The added interest can sometimes be so steep that the repayments are hard to keep up with. It’s not abnormal for payday loans to have interest rates of +1000% and, in instances like this, a lot of people can barely afford to repay the interest amount and therefore don’t end up repaying anything off the balance of the debt.
This isn't helped by the fact it’s quite hard to find out about the true cost of the debt before you sign up to it. Banks often advertise 0% interest to make you feel better about taking on the debt, and don’t make it clear that this only lasts so long so, once you’re out of the specific, introductory time period, you’ll face a steep rise in interest on whatever balance you have. These days, there are also lots of different forms of debts out there, so sometimes people get into debt without even realising it.
What types of debts are there?
There are lots of different types of debts, but most commonly it comes in the form of a loan, a credit card or a buy now pay later scheme. In the UK, we consider debt in two main categories: secured debt and unsecured debt.
Secured debt is where you borrow money against a physical asset – most commonly your home or your car in the form of a mortgage or car loan. Interest rates on secured debt tend to be lower (meaning it’s cheaper for you overall) because the lender has extra reassurance that, if you were unable to repay the agreed loan, they could repossess the asset and get the money back that way. While the low interest rates associated with secured debt is certainly a bonus, you need to be confident you can afford the repayments because the consequences of not paying are more serious. For example, if you didn’t meet the repayments on your mortgage, it could cost you your home.
Unsecured debt, such as personal loans, credit cards and buy now pay later schemes, don’t involve any assets and are therefore more expensive for you. This is because the lender will charge higher interest rates or fees to cover the extra risk. If you were to make a late, part or missed payment, the lender is likely to charge you even more interest or fees which will add to the total amount of your debt. It could also damage your credit score which could limit your ability to borrow money in the future.
What does APR mean?
APR stands for Annual Percentage Rate and, in the context of debts, refers to a percentage figure of how much you’re likely to pay in fees and interest charges. For example, if you took out a £1,000 loan with an APR of 5% for two years and weren’t making monthly repayments, the total amount you would need to repay at the end of that two years is £1,102.50.
All lenders have to tell you the APR figure before you sign any agreement, however you’ll often see banks advertise debt products with a ‘representative APR’ figure attached, which means that at least 51% of customers will receive this rate. However, a lot of customers will actually be charged more because it is dependent on their personal credit history. For example, if you have a poor credit rating, the actual APR you are offered is likely to be a lot higher, so you could get a nasty surprise at the end of the process when you realise how much you’ll need to pay back.
How much debt is too much?
Deciding how much debt is too much will vary from person to person as it really depends on your own financial circumstances. However, a good place to start is to think about amount of debt you owe compared to the amount of income you earn. This is what finance professionals would call your debt-to-income ratio.
To work out your own debt-to-income ratio, you need to divide your total monthly debt payments by your total monthly income. Then, multiply the resulting decimal by 100 to turn it into a percentage.
This figure will make it easier for you to understand how much of your money is going towards funding your overall debt. A good balance to aim for is about 35% or less. Anything higher than this could indicate that you have too much debt for the amount of income you earn.
Another way to tell if you have too much debt is to pay attention to the way you manage money each month. If you’re often making late payments, or can only make minimum payments on your credit cards, then that may also suggest you might have too much debt for what your income can manage.
If you think you may have too much debt and are struggling to get on top of it, we have another handy guide that talks about how to get yourself out of debt, so give that a read.
Can debt ever be good?
Generally, debt is considered to be a bad thing because it’s very expensive and can easily become unmanageable. However, a small amount of debt which you’re able to repay in full each month can actually be a good thing because it’ll help you to build up a solid credit history and gain a good credit score.
It’s very important to say though, it’s not the debt itself that is good. It is the way you manage it that is the positive. For example, if you use a credit card and simply use it to cover your food shopping for the month, the balance you’ll need to repay will be relatively small and you should have no trouble paying the amount in full, and on time. This shows the lender that you are a responsible borrower, which will then be reflected in your credit score.
Credit Score: A credit score is a three-digit number that reflects how reliable you are when it comes to repaying money. It is based entirely on how you have managed money in the past.
It’s in your best interest to have a good credit score because it’s what a lender will use to decide whether they should accept your application for debt, and at what rate. If you have a good credit score, you’ll likely be offered better rates which will mean the amount you’ll need to repay in interest is lower. So, while debt itself isn’t necessarily a good thing, getting into manageable debt can have its uses because it’ll help you secure cheaper deals in the future.