Debt has become a determinant of whether one is rich or poor in this modern world. The poor and the rich use debt differently. There is good debt and bad debt. 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. The focus of this article is on bad debt and this debt is a pandemic which has been passed from one generation to the other..
What is debt?
Debt’ is the total amount of money owed at a particular point in time.
When we talk of debt there are two terms that are associated with debt that is assets and liabilities. From the accounting perspective assets are things that people or an organization own at a point in time and liabilities are amounts that people or an organization owe at a particular point in time. In financial literacy an asset is defined as something that puts money into your pocket and a liability is something that takes money from your pocket.
Debt is the involuntary (automatic) inability (failure) to make payments which the payee (receiver / collector) expects to be paid immediately.
Credit is a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at a later date—generally with interest.
Features of a debt
Debt is made up of the following:
- Principal amount or the capital sum is the amount originally lent
- Interest is the cost of having debt and is expressed as a percentage
- Arrangement fee this is a charged levied by the lender for processing the loan or for offering you a credit facility
These three elements sum up the total amount that you have to pay for taking on debt. Interest payments are either made annually or monthly. One of the pieces of financial small print it is always vital to read is the basis on which interest is charged – that is, how often and by reference to what terms. Interest can either be charged on a reducing balance, flat, fixed, variable or compounded.
When you pay interest on a reducing balance it means interest will be charged on the balance of the capital sum
Flat rate interest it means that the interest is calculated on the principal amount and spread equally over the repayment period without taking regard of the fact that the principal amount is reducing. This usually applies on short term loans
Compounding interest – when interest is compounded it means that in the event you skip an instalment interest will be calculated based on the interest you failed to pay on the installment you missed – interest on interest.
Fixed interest rate – the rate of interest charged on the loan remains fixed during the term of the loan. A fixed interest rate is advantageous when interest rates rise but the lender is not able to adjust the rate upwards because by doing so they will be in breach of the contract on the other hand when interest rates fall you as a borrower you continue to pay the higher rate.
A variable interest rate – when you take a loan with a variable interest rate clause it means the rate of interest you will pay over the loan period will change as and when interest rates change either upwards or down wards. With a variable interest you benefit when the rates go lower than the rate when you took the loan and you feel a financial strain when the rates go higher than the rate when you took the loan.
When we look at the different ways in which lenders charge interest it is important that as a borrower you understand which method the lender is using to charge you interest. You must not be carried away by the rate only which you might think is low, calculate the total amount that you will eventually pay using that rate you will discover that the loan is very expensive and unaffordable.
In most cases people take on debt in order to meet funding gaps that arise from time to time or involuntarily end up in debt due to changes in financial circumstances mainly loss of employment and economic down turns. Loan providers have in recent years stepped up their efforts to get clients to borrow through advertising in both the mainstream and social media platforms. Examples include clothing and furniture stores, We have also seen the licensing of many loan providers which include microfinance institutions so consumers have a wide choice to turn to.
The majority of people today have taken on unsecured debt. Unsecured debt includes money owed on credit cards (clothing retailers issue credit cards), retail finance, overdrafts, and micro finance personal loans. The debts are unsecured meaning there is no collateral security which is offered against the funds taken.
What influences the people to take debt?
The level of economic confidence – When people feel optimistic about the future – when there is the so-called ‘feel good’ factor about the economy – they are more likely to consider taking on debts than if they are worried about the economy and problems such as falling net incomes and unemployment. This factor can be argued on the basis that if we look at the economic situations in developing countries the level of indebtedness is very high among the low income earners because of the need to meet basic needs. Most of microfinance lenders get their business from individuals the same goes for unregistered money lenders so borrowers in the low income group turn to these lenders because it’s very easy to get a loan from them than getting the loan from a bank.
A statistical measure used in personal finance to measure ‘financial difficulty’ is whether debt repayments (excluding secured loans like mortgages) are 20 per cent or more of net income. What this means is your loan repayment should not exceed 20% of your net income (income after tax and statutory deductions). Once the repayment is above 20% of your net income then it means that you can’t afford the loan. The majority of borrowers ignore this statistical measure because they think they will afford to make the loan repayments by other means apart from their salary.
Who is likely to have debt problems?
Debt is more likely to be a major problem for low income earners or low income group and those in their twenties and thirties. This group of people falls into debt problems because their expenditure tends to rise above their incomes. For example when a couple gets married their income does not change and after some time they have a baby, the coming of this baby adjust the family’s expenditure upwards and this trend continues as the family grows in number and as new expenditure (school fees, books etc.) come into effect. All this while the income level of this couple has not changed save for some cost of living adjustments in line with inflation.
Borrowers eventually slide into over –indebtedness. Over-indebtedness’ is a term used to describe debt that has become a heavy burden for the borrower. Poverty and job insecurity increase vulnerability to debt problems. A study by Ben-Galim and Lanning, 2010 showed that ‘job insecurity and fluctuations in income and expenditure can expose poorer households to debt problems’
There is a link between low-income households and financial exclusion, including having less access to mainstream banking and loan facilities. This, in turn, means that low-income households turn to alternative sources of credit. It was found that the use of credit for purchases was very common among low-income families. Since these alternative sources of credit are typically more expensive than mainstream credit – because the interest rate charged is higher – such financial exclusion increases the probability that debts become a burden and arrears are built up.
Debt problems also relate to family type. Families with children are more likely to be in arrears than households without children and, for families with children, lone parents are much more likely to be in arrears and to have two or more debt commitments. Many people can relate to this fact that family size contributes to debt problems (most of us grew up in a big family which included extended family members). It is no surprise that most of us are in debt today because we grew up in a system where borrowing was the order of the day so you got the wrong financial education. Any money problem was solved by borrowing from expensive sources, the system did not teach you how to overcome money problems. Many people today buy clothes, food, pay for entertainment using credit cards, furniture on credit or hire purchase and repayments range from six months to thirty six months. The system rewards those who keep up with their installments by periodically increasing their buying power. You are deliberately hooked to the debt pandemic by captivating words to the extent that you do not see that you have become a prisoner of debt.