Debt

Debt
Debt is money an individual owes to a lender. There are many types of Debt, including personal debt, credit card debt, student loan debt, and more. Taking on Debt can also mean incurring interest fees, meaning you’ll be charged money for the privilege of borrowing money.

What is Debt?

Debt is an amount of money that is owed by a person or business to a lender or financial institution. The majority of debt carries interest, which means that the borrower owes the lender more than the amount they originally borrowed.

How does Debt work?

Debt is created when a lender or financial institution gives a borrower a specific amount of money. This money is referred to as a loan, and can come in many different forms. Debt can be issued to both individual borrowers and businesses. This article will only address debt that is taken out by individuals, also known as “personal debt”.

A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.[1] The amount or rate of interest owed on a debt varies depending on the type of agreement that is reached between the lender and the borrower.

What is Interest?

Interest is an additional sum of money, beyond what the borrower received from the lender, that the borrower owes on their debt. Essentially, interest is the cost of borrowing money. Most interest is charged as a rate, which means that the debt accrues a set percentage of the amount borrowed over a certain period of time. However, some loans charge interest as a flat fee. The Annual Percentage Rate (APR) measures how much interest a debt would accrue if the amount borrowed was outstanding for an entire year. The APR measures not just the interest on the debt but also includes any additional fees or charges. As such, it is a better measure for understanding the true cost of borrowing than the simple interest rate.

What are the different kinds of Debt?

Any outstanding debt can be sorted into two categories: secured and unsecured.

A secured debt is any debt that is backed by collateral, which can be any valuable piece of property offered up by the borrower. Cars, houses, and real estate are all commonly used as collateral. If the borrower is unable to repay their debt, the lender can claim the collateral in order to make up their losses. Secured debt agreements are much less risky for lenders than unsecured agreements. This means that they can offer borrowers higher principal loan amounts and lower interest rates.

Unsecured debts are debts that do not involve any collateral. As such, these debt agreements depend on whether or not the lender thinks the borrower will be able to pay the debt back. Lenders will often use a borrower’s credit history and credit score to determine whether or not they are creditworthy. As these debt agreements are much riskier for lenders, they often come with lower principal loan amounts and higher interest rates?

How is Debt structured?

There are many different ways that debt can be structured, but the two most common structures are loans and credit lines. Technically, a line of credit is just a very specific type of loan. However, due to several key differences between the two, they are often considered to be entirely separate types of financial products.

Loans:

When a person is issued a loan, they are being issued a lump-sum of money. The agreements for most loans are close-ended, which means that they set a specific date by which the loan is to be paid back in full plus fees and interest. There are several different kinds of loans, including personal, auto, home and student loans. (See below for more.)

Standard Line of Credit:

With a line of credit, the borrower is not issued a lump sum of money. Instead, they are given a maximum credit limit up to which they can borrow. The borrower only owes interest and repayment on the money they actually borrow, not the maximum amount they are authorized to borrow. With a standard (or non-revolving) line of credit, the available funds do not replenish as the balance is paid down. If a borrower receives a $5,000 credit limit on a standard line of credit, they will only ever be able to spend $5,000.

Revolving Line of Credit:

A revolving line of credit is structured in a similar fashion to a standard credit line. However, with a revolving line of credit, the available funds do replenish as the balance is paid down. This means that a borrower with a $5,000 revolving line of credit could end using far more than $5,000—so long as they make sure to pay down their balance. Credit cards are a form a revolving credit where the funds can be accessed directly. With credit cards, borrowers are charged interest on their card’s outstanding balance (plus interest), and repayment is due on a monthly basis. Credit cards (and lines of credit in general) have open-ended terms; the borrower can continue to use the line so long as they always make the minimum payment amount owed, which varies from line to line and from card to card. In general, the minimum amount owed on a credit card is very small, and paying only the minimum amount could take years to pay the card off. With a credit card—as with any line of credit—the outstanding balance (including interest) is considered a debt.[2]

What are some different kinds of loans?

While all loans have certain things in common—they come with close-ended terms and are issued in a lump sum—they can also differ in various ways.

Installment Loan:

With an installment loan, the borrower pays the loan back over a series of regular, fixed payments. These are amortizing, which means that each payment is for an equal amount of money, and that each payment goes towards paying both the principal loan amount and the interest.[3] As long as the borrower continues to make their monthly payments, the loan should take care of itself. The length of term for an installment loan is usually no shorter than six months, and they are oftentimes at least several years long. Payments for installment loans are often made on a monthly basis, but this is not always so. Personal installment loans are a common form of unsecured debt. Mortgages and auto loans are also usually structured as installment loans. Mortgages are secured by the value of a house, building or another piece of real estate, while auto loans are secured by the value of the borrower’s vehicle.

Payday Loan:

This is a kind of short-term, small-dollar cash loan that works by advancing money on the borrower’s next paycheck, government benefits check or other guaranteed deposit. With a payday loan, the borrower gives the lender a postdated check for the amount borrowed plus interest.[4] In return, the lender gives the borrower a cash loan and then deposits their check on the agreed-upon due date—usually the borrower’s next payday. These loans typically have $350 principals, 14-day terms and an interest rate of $15 per $100 borrowed. Because these require lump sum repayment, they can be difficult for borrowers to repay. When this occurs, the borrower will oftentimes roll the loan over, extending the due date for an additional interest charge. Since the Annual Percentage Rate (APR) for these loans averages 322%, the cost for these loans can add up fast.

Title Loan:

Title loans are short-term, secured, cash loans that uses the title to the borrower’s car, truck, or motorcycle as collateral.[5] The value of the loan is based off of the value of the borrower’s vehicle; however, the borrower typically only receives 20 to 40 percent of the vehicle’s full value. As a part of the loan agreement, the borrower brings in their car title so that the lender can either keep it or register a claim against it. If the borrower is unable to pay back the title loan, the lender can then repossess the car and sell it to recoup their losses. These loans have an average principal loan amount of $952, an average term length of one month, and an average interest rate of 25 percent. Their average APR is 300 percent, which means that having this loan outstanding for a year would cost the borrower 300 percent of what they borrowed in fees and interest alone. Due to their large principals, high rates, and short terms, many borrowers have trouble paying their title loan off on time. As such, they roll the loan over, receiving another month to pay the loan back in exchange for an additional interest charge. Because of the high risk of mounting debt and vehicle repossession, title loans are considered predatory.

What is good Debt versus bad Debt?

Good debt is seen as a productive investment in a person’s future earning power or overall net-worth. Student debt is seen as good debt since the borrower will receive an education that will allow them to earn more in the future. Mortgage debt is seen as good debt, as the house or real estate purchased is an asset that will (hopefully) increase in value over time. On the other hand, all consumer debt (such as debt taken out paying for food, clothes, electronics, even cars) is seen as bad debt; this is because the things or experiences purchased through consumer debt do not increase in value over time or increase a person’s future earning power. Credit card debt is the number one kind of consumer debt and is thus the most common type of bad debt. Too much bad debt will hurt a person’s credit score.

What is a credit score?

A credit score is a number based on the information in a person’s credit report, which tracks their history of debt management. The FICO score is the most popular kind of credit score, and it is based on scale from 300 to 850. The higher a person’s credit score, the better their credit rating. Many lenders will look at your credit score (and possibly your credit report too) before offering you a loan, especially if the loan is unsecured. As such, having a good credit score is of vital importance when borrowing money. People with better credit scores will get have more options when borrowing and will get offered more favorable terms. People with not-so-great credit scores will have to pay higher rates and will be approved for fewer loans.

References

  1. “What is Debt?” Investopedia. Accessed July 20th, 2016. http://www.investopedia.com/terms/d/debt.asp
  2. “Revolving Debt”. LendingTree. Accessed July 20th, 2016. https://www.lendingtree.com/glossary/what-is-revolving-debt
  3. “How amortization works” Banking.com. Accessed July 20th, 2016http://banking.about.com/od/loans/a/amortization.htm
  4. “Why you should never use a payday loan” Moneynation.com. Accessed July 18, 2016. http://moneynation.com/never-use-payday-loan/
  5. “Single-Payment Vehicle Title Lending” ConsumerFinance.gov Accessed July 20th, 2016. http://files.consumerfinance.gov/f/documents/201605_cfpb_single-payment-vehicle-title-lending.pdf