Indebtedness is something that most of us will experience at one time or another. It isn’t necessarily a bad thing. In fact in some instances, taking out a loan is the only practical way forward. Take buying a property as an example.
Whatever the type of loan you’re thinking of taking out (a mortgage, a bank loan, finance on a new car, or a payday loan) you need to fully understand the nature of debt, and how it impacts on your financial situation.
Debt is an legal and moral obligation
Debt is an obligation; not just a moral obligation, but a legal one too. Organisations that lend money do so as a business, and if you are unable to meet the repayment schedule, they can take legal action against you to recover what you owe.
The important thing is not letting things get to that state, and the only way of doing this is to do your research carefully before taking on any sort of debt.
The difference between good debt and bad debt
When thinking about taking on a debt, the first thing to determine is whether the loan you are contemplating will be a good debt loan or a bad debt loan. Good debt is the sort of debt that will eventually better your financial standing – a student loan for example.
The aim with this sort of loan is to improve your chances of future employment and to enable you to earn a higher salary. You are in fact investing in your own future.
Alternatively, you might be thinking of taking out a business loan. If the business is successful, it will provide you with a good source of income. You will however be expected to develop a sound business plan before anyone will be willing to invest,
Bad debt on the other hand is something you ought to try and avoid. This type of debt is not an investment. It is really a way of enabling you to purchase something that is more frivolous in nature; say a holiday for example. Once you’ve acquired the debt, you have little or nothing to show for it – certainly in financial terms.
Understanding interest and arrangement fees
Whatever the sort of debt you are thinking about taking on, you need to understand what it will cost you. Interest free loans are few and far between. The vast majority of loans will involve some sort on interest, and this is something you need to fully understand.
The interest on a loan is what makes it worthwhile for the lender to loan you the cash. Generally speaking, the shorter the loan term, the more interest will be charged. A long-term loan like a mortgage, which can be taken out over 20 years, will have an interest rate of say 10% per annum.
At the other end of the scale, a short pay-day loan which normally has to be paid back within 30 days or less, will have an interest rate of anything up to 60%, which is the limit set by National Credit Regulator (NCR) here in South Africa. Although this might sound high, you must bear in mind that it is an annual figure, and typical payday loans are only taken out for a number of days.
The other thing you need to be aware of when trying to understand debt is that the lender will often charge a service fee on top of the interest rate. This too must be paid back with along any interest that has accrued.
In conclusion, when you repay any loan, your payment(s) will comprise the original sum you borrowed, plus any interest that has accrued, plus the lenders service charge (sometimes referred to as an arrangement fee).
Be aware of any penalties for defaulting on repayment
To get a total understanding of debt, you also need to take onboard the fact that if you do default on the repayment of a loan, you will probably incur some sort of financial penalty. In other words, if you fail to comply with the rules of the agreement, you could end-up being significantly worse off, which it’s why it is so important to understand the full picture.