Good debt is one which you take and you get someone to pay on your behalf and bad debt is one which you take and pay by yourself. Before taking any debt it is important to take time and compare the costs of different debt products. Never be under any increased pressure more than the pressure you are already in, to just take any loan before ascertaining the total cost of the loan.
Lenders charge interest so as to have a return for taking the risk associated with not getting their money back. As you know in investing higher risk higher return so when the lenders deem you are a high risk they will charge you a higher rate of interest. They will not tell you that you are a high risk but know from the interest you get charged that you have been deemed a high risk. Interest charges also vary according to the security offered to the lender by the borrower.
Secured debts (loans with collateral security) usually have a lower interest than unsecured debts. This is because the lenders will have something to sell to recover their money. The size of the loan determines the rate of interest charged. A large loan attracts a lower interest than a small loan. The competition between lenders determines the rate of interest they will charge to borrowers. The greater the competition between lenders the lower the rates will be. I have noted that the demand for loans out trips the supply as such interest rates among micro money lenders both licenced and unlicenced have remained high over the years.
Reasons for problems with debt
Job loss – when one loses a job they are bound to end up in debt problems because of loss of steady income
Living long term on low income – an individual or a couple might fail to have their level of income change over time yet their expenditure continue to rise resulting in them taking on loans to cover the cash flow gaps. This mismatch in income and expenditure results in debt problems.
Over commitment to high levels of spending – people have a tendency of thinking that they will somehow be able to get some extra income after taking on debt something they are not able to do before taking on debt. This mindset causes them to overcommit to high levels of spending which result in problems with debt.
Unforeseen or unexpected life events like sickness cause people who are already in debt to end up in debt problems.
Debt products offered by lenders
The following debts products are offered by lenders
- Overdrafts
- Credit cards
- Personal loans
- Hire purchase
- Mortgages
- Alternative credit from unlicenced lenders
All these products come with different terms and conditions suitable for each borrowing need
A key determinant of being able to access debt products is the credit standing of the borrower. People with poor ‘credit scores’, even if they have high incomes, will have limited access to cheaper forms of debt. Most lenders ‘credit score’ loan applicants before releasing money. The credit score analysis can be broken down into four main areas:
- Factors which might automatically prevent approval: a court judgement against the borrower for previously defaulting on debts.
- Affordability testing: This looks at the income and prevailing expenditure commitments of applicants, with an emphasis on existing debts. The 20% rule comes into effect here, if the instalments exceed 20% of your net income it means that you can’t afford the loan.
- Characteristics of applicants: For example, how long someone has lived at their current address (and at previous addresses), and how long they have maintained their current banking arrangements will be scored. Frequent changes of address and banking arrangements attract unfavourable credit scoring because you will be considered a high flight risk or likely to be untraceable.
- Security: This relates to the importance of collateral security in deciding the level of risk and the interest rate.
Obtaining a favourable score in this analysis does not mean that one will not fall into debt problems. The ability to stay up to date with loan repayments is a function of how disciplined one is in keeping his or her expenditure in check and not missing any instalment.
Once you take on debt always remember to redo your budget and incorporate the monthly loan repayments that you will be doing for the loan duration. What drives people into debt problems is not having a financial picture of how their life will turn out to be after the instalment has been deducted from the salary or by the bank. You need to decide on which items to forgo because of the instalments it’s not a-we will cross the bridge when we get there kind of approach. You dig your own financial hole by lack of proper planning and financial discipline. Once you start missing instalments the “small print” starts to be enforced by the lender and the debt start to grow faster because of interest compounding, late payment charges etc. All these issues feed this trans-generational pandemic and it’s no surprise that it’s still here today.