What is Debt?

Debt is when someone borrows money from someone else. This can help or injure your financial life, based on how much debt you decide to take and how you intend using it.  Debt is money that a person owes another, this could be another person, business, organisation or the government. The minute you borrow money, you make an arrangement with the lender to repay the money based on a set schedule and sometimes with interest. Most people understand about student loans, loans which are short term, car loans and credit cards.

Is Debt Good or Bad?

All debt comes at a price with any money borrowed being either good or bad debt, which is based on how it impacts your life and your finances. Good debt will help you build wealth and increase your income, while bad debt doesn’t offer any benefits or a return once it is repaid.

Home loans and student loans are classified as good debt, as they help you build your wealth and increase earning potentials. On the other hand, personal lines of credit and credit cards are bad debt, there is no return on investment with high interest rates, which means you repay more than you borrow in the long run.

It is important to note that even good debt can quickly become bad debt if you have signed an agreement with unfavourable terms, such as high interest rates which prevent you from being able to save or invest due to the high repayments.

Understanding How Debt Works

Most people will take on debt when they want or need to make a purchase, which is more than they can afford in cash. Maybe they want to use their cash for something else, borrowing the money can be an easier way to purchase what is necessary at the time.

In some cases, you find that debt can be only be used for specific things, such as you can only use a home loan to purchase a property or a student loan to pay your educational expenses. These debts, the consumer does not receive the money, the amount borrowed goes directly to the person or company that provides the services. For a home loan, the money is send to the sellers bank, for example.

A person is only able to manage debt based on income and expenses. When you find that you have too much debt, you may find yourself bankrupt. Bankruptcy is a legal proceeding that releases the debtor from certain debts, eliminating the risk of creditors requiring payment.

Different Types of Debt

Debt is usually placed in two categories, secured and unsecured debt. Secured debt is when the lender can seize assets, known as collateral, should the consumer default on their agreement. This is usually for large amounts, such as car loans, home loans and secured credit cards. Once the consumer has defaulted on their repayments for a certain period, the lender has the right to take away assets, which can be a property, for example. It’s not uncommon for the consumer to still owe money after the items have been recovered, if the sale of the assets are not enough to cover the loan balance.

Unsecured debt is not connected to assets or collateral and does not give the creditor the right to take property or assets should the consumer default on their agreement. Unsecured debts are usually credit cards, payday loans and student loans, for example. Unsecured debt are short term loans, which are risky, such as payday and instalment loans. When unsecured debt is not paid, the lender will sell the debt to third party collection agencies who will call, send letters and add the unpaid debt to the consumers credit report. If all fails, they are able to ask the court for permission to collect the debt via the consumers monthly salary.

Revolving credit is another form of debt, usually a credit card. As long as a minimum monthly repayment is made, the consumer can continue using the balance available.