What is Debt and How to Handle It
Debt is money owed by one party to another. If you repay your debts, you can continue to borrow - and will likely be able to borrow more.
Debt is something you owe, usually a sum of money, to another person, bank or organisation, having borrowed it with an agreement that it will be given back or repaid with terms attached. These terms may include a date by which the debt will be settled, or an amount of interest or fees you must pay for the privilege of borrowing the money.
Most people take on debt because they want to buy something they cannot afford upfront.
Living outside your means is often frowned upon and it can be distressing if you get into a situation where you are struggling to repay the money you owe by the deadline agreed, or perhaps because the interest you have to meet is high and it is costing you a lot over the borrowing term
Why debt can be a positive
But being in debt is not always a bad thing and can even have some positives.
Borrowing money can be a tool to allow you to earn or achieve more over the long run than you would have been able to if you had relied on your salary alone.
For example, getting into debt with a mortgage is for most the only way they can afford to buy their own home, which could work out more cost-effective than renting in the long term.
Most students would not be able to afford to get a university degree, which can enable them to fulfil higher-paying professional ambitions, become a doctor, lawyer, or architect, without taking out a student loan.
Even smaller debts, money borrowed via a credit card or a car loan, can help people improve their quality of life or business prospects. Those such as the self-employed, who have a bumpy income where how much they earn varies from month to month, may also need to get into debt in order to continue their chosen career.
However, when deciding to get into debt, it is not always transparent how much it will cost you over the months or years, so it’s important to do what you can to understand the cost of going into the red.
Usually, when borrowing money, you will enter a contract where you agree how long you will take to repay it. In the case of a mortgage, this could be decades, with a bank loan it could be a couple of years, while for a payday loan it may be just a couple of days.
Some debts, like credit cards, are open-ended, in that you can take as long as you like to repay them, provided you meet minimum interest payments each month. But taking a long time to repay usually works out much more expensively.
The amount you are charged for the debt, usually set as a percentage interest rate, also varies depending on the size of the sum you are borrowing, as well as how reliable a borrower you are, which is measured by looking at your credit file. The better your credit score, the lower your interest rate is likely to be and therefore the cheaper the cost of your debt.
» MORE: How to improve your credit score
How you repay your debt will also vary depending on the kind of debt you have and how it is structured. For example, a mortgage may be made up of capital as well as interest repayments.
» MORE: How to get out of debt
Some mortgages are structured as interest-only, where you just repay the interest on a monthly basis and only clear the capital on maturity.
Student loan debt repayments are made based on how much you earn and deducted from your pay, a bit like a tax.
Some debts, such as personal loans, can only be repaid in instalments and you may be penalised with an early repayment charge for clearing them faster. In other cases, such as with a credit card or payday loan debt, repaying in full means you will be charged less or no interest. The longer you take to repay the debt, the more interest you will pay.
How much can I borrow?
How much you can borrow may also depend on your debt-to-income ratio (DTI). This is a percentage looked at by some lenders, representing how much of the amount you earn each month goes towards your existing debts.
To work out yours, tot up all the money you owe on debt repayments each month, including things like your mortgage, credit cards or bank loans, student loan or car loan. Then work out the amount you have coming in, your monthly income, such as salary, benefits, or earnings from elsewhere. Divide your debt sum by your income sum and multiply it by 100 to get your DTI percentage.
» CALCULATE: What is your debt-to-income ratio?
The lower the number the better. If your DTI is too high the lender may think you can’t cope with the additional burden of more debt.
For mortgages a figure between 40-49% is likely to be regarded as moderate risk so you may need a larger deposit and an excellent credit score. Between 30% and 39% would be regarded as an acceptable risk, but ideally for access to the widest range of lenders and the best possible terms a DTI below 30% is likely to be preferable.
What happens to my debts when I die?
Many believe that debt is wiped out on death, that is true of student loan debt, but most other kinds of debt will have to be repaid by executors from your estate, which includes any property, savings or money you leave behind. Your family will not have to repay your debts, unless they are jointly owned, if you do not have enough money in your estate to clear them.
What happens if I can’t repay my debts?
If you are struggling to repay your debts or afford your interest payments there is help available and you should seek it as soon as possible, as the longer you ignore the problem the worse it will get. Be wary of anyone who charges you money to help consolidate your debts or manage them better. Try debt charities such as StepChange which offer specialist debt advice, free of charge.
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Laura is a journalist and author, writing about money since 2008. Including writing for The Times for 9 years. She believes finance doesn't need to be complicated. Author of Money: a user's guide. Read more