You may have heard it said that there is such a thing as ‘good debt and bad debt’. In some senses this can be true, for example for most people the only option in becoming a home owner is through an income-assessed mortgage, which is a form of debt.
However, the borrower's ability to repay the mortgage debt is carefully checked by the lender under very specific Financial Conduct Authority regulations, making a properly balanced mortgage manageable assuming that the borrower maintains the same levels of income (salary) and outgoings. Student loan debt is also ‘good debt’ as it is only repaid when the borrower hits a certain level of income. Even then it is repaid at a level which is linked the borrower's salary and is taken out at the point of Income Tax.
In essence most of us repaying student debt for tuition fee and maintenance loans make the repayments before we even get our salary into our bank account. Another significant factor of these ‘good debts’ is that the interest rates are very low, typically around or below 5% although interest rates do rise and fall in line with the performance of the wider economy.
However most other forms of debt can easily be considered ‘bad debt’. This could be unsecured bank loans (i.e. loans made which are not borrowed against a major asset, such as a house), credit card or store card debt, loans from payday lenders or even loan sharks.
These are ‘bad’ because the borrower may not have taken much (if any) of your financial circumstances into account when offering you the loan, meaning that you simply may not be able to make the repayments, in which case penalties will kick in which can range from additional fees/interest rate hikes through legal action (such as a County Court Judgement or Small Claims Court) to visits from a bailiff to repossess goods and assets.
Bad debts are also characterised by very high interest rates which again can range from around the 5% level (for high street bank personal loans) to averages of 10-15% for credit cards and up to the eye-watering 1000+% interest for pay-day lenders.
Pay-day Lenders are high risk options, often targeting those who are unable to secure lending from banks because of bad credit or a lack of assets to secure their loans. Pay-day lenders market their loans as ‘short term’ and as such charge extremely high interest rates often on relatively small loans. Often if these loans are not repaid within the agreed period it is common for administrative fees and the high rate of interest charged to cause the repayments to escalate rapidly.
This article published by the Independent newspaper explores some of the issues surrounding students and pay-day lenders.
One thing that all of the above lenders have in common is that they are legal, which means that they have a license from the appropriate authority. Loan sharks is a general term for unlicensed lenders, individuals who make doorstep loans often to those who are financially or socially vulnerable and charge interest rates that make payday lenders seem reasonable. In addition the tactics used by these lenders to secure repayment can be illegal and dangerous.
A quick word about interest rates. This is the ‘charge’ made on the money you borrow and it’s how the lender makes a profit on your loan.
Basically the percentage interest rate is what is added to your basic debt and will continue to be added until you pay the entire balance off. The exact period over which the interest is added varies from loan to loan and you should always check the small print.
As an example if you borrow £100 at 10% interest which is added every month then after one month you’ll owe £110. If then you repay £50 of that loan in the next month you’d still owe £66 (£110 - £50 = £60 plus 10% interest = £66). Factor in a different £100 loan with an interest rate which is advertised as being 1000% and you can see how this debt can quickly get out of your control.
You will often see a figure called ‘APR’ quoted, this stands for ‘Annual Percentage Rate’ which is sometimes used just to give a comparative idea of what the level of interest is likely to be over the rate of one year. In some cases though this is the actual interest that is applied over the year broken down usually into daily or weekly interest, so an APR of 1000% applied daily (2.7% per day) would mean that a £100 loan would be debt after one day of £102.70, £105.50 after two days and after two weeks would have increased to £146.52 – a rise of 46% in fourteen days!