What is debt?
Debt is a sum of money that has been borrowed under the condition that it will be paid back at some future point. An amount of interest is also usually agreed to be paid by the borrowing party.
Governments and companies use debt as a way of financing expensive projects which can not be paid for using current cash flow or cash reserves.
Debt exists in many different forms, but generally involves:
- Two parties agreeing that one will lend the other money
- A schedule of repayment, and of interest payments
- If interest is to be paid, an agreement between the two parties as to the rate of interest and the scope for that rate changing
Debt exists in many different shapes and at very different scales. On a personal level, practically everyone will take on at least some form of debt in their lifetime, whether you get an overdraft, take out a loan, or get a mortgage to buy a house. Taking on debt, if done sensibly, can be of great benefit to you.
The term ‘consumer debt’ (or ‘personal debt’) simply refers to all the money which is owed by individuals or families, rather than debt which is owed by governments and corporations.
A mortgage is a prime example of consumer debt, and one which is necessary for the vast majority of people if they wish to become homeowners. House prices are worth multiple times the average wage, and far surpass average savings in the UK.
A mortgage allows people to get on the property ladder by taking on a large, long-term loan to buy a home. This is usually paid off along with an additional charge for the rate of interest.
A mortgage is a type of secured debt, meaning it is offset by a tangible asset. This provides security for lenders, allowing them to offer lower interest rates, but means borrowers failing to keep up repayments can have their homes repossessed.
Due to the high cost of most forms of higher education, most students in the UK will need a loan from the government to cover the costs. With annual tuition fees of £9,000 for the majority of courses as well as the cost of living away from home and unpredictable interest rates, student debt can be considerable – totalling over £40,000 in many cases.
However, student debt works in a different way to most forms of debt. Because university education is seen as beneficial for all, the money is repaid in small instalments relative to earnings and is often never fully paid off. In fact, most people repaying student loans have a set date at which the debt will be written off.
Additionally, a large student loan does not affect things like credit scores in the way that other types of loans do. Student debt is the subject of debate in the UK, with some believing it to be burdensome on young people and others arguing it is manageable and acts as a kind of ‘graduate tax’.
Credit card debt
Credit card debt is an extremely common way for people to make purchases which would otherwise overstretch their finances. Buying an item on credit allows consumers to obtain goods straight away rather than saving for them, albeit at the cost of having to pay interest. Interest is only waived if everything is repaid by the account’s due date – doing this is a good way to build your credit score.
Like any form of debt, using a credit card sensibly is a good way to afford something slightly out of your financial reach, but failure to manage credit card debt can be damaging. Credit card debt is unsecured, meaning it is not tied to a specific asset – this is why interest rates on credit card debt can spiral and borrowers can get into hot water if they can’t pay what they owe.
Corporate debt works in a very similar way to consumer debt. Corporations may need to take out a loan to fund expensive projects, expand their operations or even pay off other debt. However, there are some options available to companies, other than traditional loans, to raise finance and take on considerable levels of debt quickly and with lower interest rates.
Corporate bonds are a common type of debt for companies to hold. A single bond acts as a small loan with an investor. The loan will be repaid at the end of the period and the investor will receive interest as compensation for loaning the money. For example, if a company wants to raise £1million, they could issue 10,000 bonds priced at £100 each.
Bonds are attractive to corporations as they allow them to raise finance rapidly, while paying a more favourable rate of interest than they would on a conventional bank loan. Governments also issue bonds in much the same way to finance spending on new policies and infrastructure projects. Government bonds are generally considered safer for investors than corporate bonds, with interest rates typically much lower.
When large corporations need short-term capital, usually to pay off other debt, they may decide to issue commercial paper. Commercial paper is a type of unsecured debt which operates in a similar way to bonds, except their terms are far shorter. While a corporate bond may last for 10 years or longer, commercial paper usually has a term of no longer than 270 days. Commercial paper is also typically issued in far larger denominations than bonds – unlike bonds, they are not affordable investments for most people.
With high levels of personal debt being so common and sometimes necessary, many people struggle to cope with shouldering multiple debts. One solution some turn to in order to reduce the burden is debt consolidation. Consolidating debt essentially involves combining all your debts into one.
Debt consolidation is a popular option, primarily because of how it reduces the confusion of paying off many separate debts. Different repayment dates, repayment amounts and interest rates can all understandably be confusing which is why it can be tempting to have just one loan to deal with. In some cases, a debt consolidation loan can also reduce the total amount you have to pay, if you manage to secure a favourable interest rate. Additionally, it can help with cash flow month-to-month – having money leave your account at several different intervals can cause confusion and affect your budget.
Debt consolidation may not be the right option if it significantly increases the amount you have to pay. A poor credit score will mean the interest on the loan will be higher, while a longer-term loan will likely lead to you paying more in the long run. Before entering into a debt consolidation agreement, it’s important to work out whether it will cause more trouble and stress in the long run than it saves.
Can debt be good and bad?
The relative merit of taking on debt is often a personal consideration. However, there are certain types of debt which are broadly considered to be ‘good’ or ‘bad’, based on what a borrower gains from them.
- A mortgage – Purchasing a property is a massive undertaking for most people, but gives you a strong, safe asset which can increase in value. This isn’t to mention the stability of owning your own home brings rather than paying expensive debt
- A student loan – Higher education may be expensive, but a student loan can enhance your long-term earning potential.
- Corporate bonds – Bonds are facilitate the long-term growth of a company. A large project or a merger is likely to make a corporation more valuable and profitable in the future if the debt is managed well. These can offer good value to investors looking for stable income.
- Credit card debt – Credit cards can be useful and beneficial if used correctly. But if borrowing gets out on control, repaying this debt can prove exorbitantly expensive.
- Any corporate debt which overstretches the company – While most types gives companies the opportunity to expand and keep up with competitors, a high overall level of debt can be dangerous as any fall in revenue could lead to financial difficulties.
- A payday loan – Turning to payday loans to make ends meet is unfortunately unavoidable for some people. This type of debt is classed as bad, however, because of the high levels of interest it incurs and the way the debt can mount up quickly.