Debt, like death and taxes, it’s a fact of life for many people. Relatively few people could buy houses without it, increasingly young people rely on it to fund their education and many businesses use it to speed up their growth. At the same time however, debt can be a real problem both for borrowers and for lenders. Borrowers need to find the funds to repay the debt, even if their circumstances change and lenders need to deal with the fact that some borrowers are not going to repay anything like the whole amount borrowed. So when does debt become a problem and how do you manage it?
Not all debt is created equal
Debt is a catch-all word which describes a huge range of different possibilities. At a basic level, you have secured debt versus unsecured debt. Secured debt is backed by an asset, whereas unsecured debt, as its name implies is not. Of course the value of the asset behind a debt can go down as well as up, which is why mortgage lenders value deposits, which protect them from short-term fluctuations in the housing market. Unsecured debt can be turned into secured debt through a legal process so those with assets such as houses could find themselves being forced to sell them to pay back debts they thought were unsecured.
Interest rates make a huge difference to the effective cost of a debt.
Let’s say you borrow £100 and promise to pay it back after a year. If your rate of interest is 1% per annum, then you will wind up paying back £101 whereas if it is 100% per annum, then you will wind up paying back £200 – quite a difference. If you think the 100% APR was an extreme example, then you might be shocked to hear that mainstream payday loan companies can charge over 1000% APR, hence how people can wind up “paying back” vastly more than they borrowed in the first place. Of course, most mainstream lenders charge far less than this, particularly for secured debt, but even so, borrowers can wind up paying a high price for so-called “consumer debt” such as spending on credit cards. Hence the same level of debt might or might not be classed as problem debt depending on the interest rate, for example £100K of mortgage debt is an entirely different situation from £100K of credit card debt.
So how do you manage debt?
The answer to this question will be different depending on whether you are a borrower, lender or regulator. For borrowers, arguably the best course of action is only to take on minimal debt for a short a time period as possible and only use debt to finance investments such as a house, an education or essential business assets. In other words, avoid using “consumer debt” to finance discretionary purchases. For those who are already struggling, the best advice would be to go and speak to a debt-management advisor, for advice tailored to your own situation. Lenders have to balance lending enough to make a profit with making sure that they refrain from becoming over-exposed to defaults. Regulators have to look at the overall situation and give appropriate guidance (or set appropriate rules). They have already made significant changes to the mortgage market by obligating lenders to look beyond headline income figures and actually analyse a potential borrower’s lifestyle to see if they can afford the requested loan over the long term. It will be interesting to see whether or not regulators move to place similar obligations on lenders operating in the consumer credit market.