Debt Management
What is Debt?
Debt is something (typically money) borrowed from one party to another. It is an obligation that requires one party (the debtor) to pay an agreed amount to the other party (the creditor). This is typically repaid in many small
instalments (monthly or yearly repayments) rather than as a single lump sum. Often, there will be an interest rate (which can almost be seen as a cost of the debt), which will need to be repaid in addition to the total value
borrowed.
Essentially, there are two types of debt:
- Good Debt: debt which increases your net worth or helps generate value. It helps you manage your finances effectively.
- Bad Debt: debt which does not increase your wealth or is used to purchase goods or services which may have little or no lasting value.
How Debt Can Grow.
As shown by the
compound interest calculator, we can see how compound interest can grow your wealth many times larger than its initial value over time. However, this works both ways, both
with increasing wealth, but also in the growth of debt. And very often, loans and other forms of credit have interest rates at an order of magnitude larger than any long term investment. I will give an example below:
- An initial debt of £1000
- An APR (interest rate) of 25% (the average UK value for credit card debt).
- And a growth of 5 years.
As you can see by the graph, by the end of five years, that £1000 has more than tripled in those five years to a final value of £3445.80.
Remember, this is only an example to show how quickly un-managed debt can grow, and normally
one would be paying money back each month, but this is definitely not a situation you would like to be in.
Some Examples of 'Bad' Debt.
As stated before, there are two main types of debt: good and bad. Here we will discuss some examples of bad debt.
- Payday Loans: these are typically very high interest, and also can reflect very poorly on your credit report. They make it very easy to get into a cycle of borrowing and repaying.
- Car finance: this is also a form of lending, and despite the fact that a car retailer may claim it is a good idea, it is always better to only buy a car if you can afford it outright. Furthermore, car finance can also affect how much money you may be lent if you are applying for a mortgage for example.
- Credit Card Debt: credit card debts also often have very high interest rates, and unless you are repaying your credit card in full every month, it can become very dangerous to use for heavy spending.
Some important things to remember.
- A creditor is here to make money: you being in debt benefits the creditor, due to high interest rates and the like, you often will result in needing to pay back more than you lent.