Good Debts and Bad Debts
A Sense for Money
There’s been a lot of talk lately about debt. From the perspective of a country such as Greece, debt is ominous, as the country faces severe financial consequences which have resulted in unrest in the streets, and the unraveling of the European Union.
Why has this happened? Is being in debt necessarily a bad thing?
Let’s start with a clarification of what a debt and interest are.
Debt is simply when you owe money to someone else; maybe a bank, someone in your family or a credit card. You have borrowed someone else’s money for a period of time, and you have to give it back. You are in debt as you owe the money you have borrowed from the lender.
Interest is a payment made for the use of someone else’s money. A friend may lend you some money and ask for the same amount of money to be returned later. In this case, the interest rate is 0 percent. When you borrow money from a bank, it may charge you an interest rate of between 7-15 percent. A credit card for example, might charge an interest rate of between 30-42 percent, for the amounts which you have charged to your credit card, but have not made payment in full. A loan shark may demand an interest rate exceeding 100 percent, where you would have to repay at least double the amount of cash that you borrowed.
You should always look carefully at both the interest rate and the period over which it is charged to see the effects of compounding interest (where you pay interest on the interest). For example, a credit card may charge 2 percent interest each month, which may seem reasonable. But if you do not repay the amount in full, then the following month you pay another 2 percent on both the amount you owe and also on the interest that you owe, and this equates to an annual interest rate of 27 percent.
So, why is there such a difference in interest rates? Basically it comes down to your standing as a borrower and the convenience of the service.
A bank may lend at 7 percent, but only to their customers who have an account in good standing, with money credited regularly into the account each month. By this, the bank can judge its risk of lending money to you, i.e. your credit worthiness. Hence, if you regularly have money deposited to your account, your risk as a borrower is regarded as low by the bank, which means that the bank regards you as being able to repay the debt. In this case, they usually charge a lower interest rate.
A credit card company may charge an interest rate of 30 percent, because you are paying for convenience of having the credit card company pay for your purchases first. Quite often, people don’t notice the high interest rate charged by their credit cards. They fail to read or understand the fine print which comes with credit card application forms, or they simply don’t ask about making payments because they think the sums of money involved tend to be small. If you pay off your credit card bill each month in full, there’s no interest to pay. But you will pay high interest rates on any balance not repaid. It’s the price you pay for convenience.
Loan sharks charge high rates as often, their customers don’t have any other choice. These borrowers may not have bank accounts, or the bank may refuse to lend as they have doubts on getting their money back. Or maybe the borrower is simply not aware of other alternative sources of raising money.
Finally the careful use of “good debt” can often smooth the ups and downs of financial life and increase your overall wealth.
The following shows how some debts are better than others. In which category would you place your debts?
- Where the debt is being used to buy an asset that increases in value (property, land).
- Where the debt is short-term and being used to make savings (buying something on sale).
- Where the interest rate is very high.
- Where the interest rate is much higher than alternative sources of finance (a credit card compared to a bank loan).
- Where the payment to service the debt is a strain on your budget (you have borrowed too much and cannot afford the repayments).
Next week, we’ll look at the questions you should ask before you borrow money and how to reduce your debt burden.