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Understanding the Debt Concept
 
 

Understanding the Debt Concept


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Key Definitions

1. Income – This is money received on a regular basis through investments or for work or services offered to another person or business.

2. Disposable income – This is income remaining after deducting taxes as well as other compulsory charges, available to be saved or spend.

3. Debt-to-income ratio – This is the percentage of a person's gross income that is used to repay debts.

4. Tax deductible – This is the ability to subtract an expense from taxable income when computing tax due.

5. Nontax deductible – This is an expense that does not affect tax.

What Is Debt?

Debt is simply defined as an amount of cash borrowed by a person from another person, a financial institution, or the government. For instance, if you go to a bank and borrow $50,000, this will be considered a debt – you will owe the bank the $50,000 plus the interest accrued thereof.

Debt is used by both individuals and corporations as a way of making big purchases which they cannot afford under ordinary circumstances – purchases they can't finance upfront.

A debt agreement, also called debt arrangement, is the document used to give you the authorization to borrow the cash and the conditions under which you will repay the money at a future date, and often with interest.

Consumer debt refers to debts that arise from purchase of goods that do not appreciate in value and/or are consumable. Possessing some level of consumer debt pays off if the debt was incurred to purchase an asset needed to boost one's earnings. For example, borrowing to finance a car is a wise decision if you need it to travel to work at a higher paying job.

However, high level of consumer debt is not good because it puts too much strain on your income. If unchecked, consumer debt can lead one into the debt spiral and/or bankruptcy.

The Difference between Debt and Credit

In general speaking, debt and credit are used interchangeably, but in strict financial terms, they have distinct interpretations.

Credit is a financial device that businesses and individuals try to obtain from financial institutions. So, financial institutions don't offer debt, they offer credit. For instance, banks, credit unions, and credit card companies offer different type of credit to their customers. These include:

  • Mortgage loans

  • Payday loans

  • Credit cards,

  • Automobile loans and more.

However, credit and debt are related in that credit is the initial portion of a debt transaction - you must have credit before obtaining debt. The following points further clarify the difference between credit and debt:

  • Before obtaining a mortgage loan, it's available to you as credit, but the moment you obtain it, it becomes a debt. So

  • Individuals normally seek debt counselling, not credit counselling. They need debt counselling if they have accumulated large amount of debt. On the other hand, they need credit counselling to help them prudently utilize the credit available to them.

  • Repayments are made to service accrued debt, not credit.

The Difference between Loans and Debts

In both personal and corporate finance, money borrowed from financial institutions is called a loan, and money obtained from the public - through issuance of bond for business - is called debt. Note the following;

  • Loans are just one part of personal debt.

  • In corporate finance, loans and debt are collective called liability of the company.

The Current Status of the Global Consumer Debt

Today, debt is one of the biggest problems facing households, small business entrepreneurs, students, and businesses. In fact, the United State Federal Reserve estimates that Americans owe more than $2.6 trillion in consumer debt, which is slightly over $11,000 per person. However, what is even more worrying is the fact that this figure does not include home equity loans and mortgages.

The Federal Reserve further show that over the last two decades, consumer or personal debt has been increasing at an average annual rate of 4.10 percent compared to the 0.60 percent increase of the middle household earning. This has raised the debt-to-income ratio to the highest level ever and created severe financial problems for many people.

The following table will help you understand the current situation of the global consumer debt. It shows the debt, income, as well as house prices in 2013 per household.

Census Division

Average Mortgage Debt

Average Non-Mortgage Debt

Average Total Debt

Average Household Income

Middle Class House Prices

Northeast

New England

$50,518

$17,883

$68,401

$86,283

$273,638

Middle Atlantic

$37,610

$17,189

$54,799

$80,582

$237,011

Midwest

East North Central

$31,720

$15,532

$47,251

$65,877

$142,044

West North Central

$36,133

$16,043

$52,175

$67,020

$147,320

South

South Atlantic

$37,495

$16,138

$53,633

$71,632

$167,713

East South Central

$24,605

$14,532

$39,137

$57,510

$125,810

West South Central

$24,671

$15,260

$39,931

$65,843

$128,043

West

Mountain

$43,386

$16,177

$59,563

$70,511

$180,294

Pacific

$54,573

$15,259

$69.831

$82,134

$315,135

United State

$37,952

$15,898

$53,850

$72,253

$174,410












Computing and Understanding Your Debt to Income Ratio

Enter details about your family or personal income in the worksheet below to compute your debt-to-income ratio. Start by entering your monthly disposable income (take home income) and your monthly debt repayments. Then, use the calculation key (below the worksheet) to calculate your ratio.


NB: Picture it this way, when more of your income goes toward paying interest and principal on your debt (a high debt-to-income ratio), you are left with less cash to spend on goods and services.

The Concept of Good and Bad Debt

Simply put, good debt refers to amount borrowed to finance an investment that grows over time -such as a school loan or a home mortgage. Your student loan is considered a good debt because it comes at significantly low interest rate compared to other types of debt, and because education is a lifetime investment in your career.

Good debt can also be defined as debt accrued to finance projects that generate income or cash flow, such as rental property or a business loan. Just to note, a mortgage is considered to be one of the best types of loans becomes it accumulates wealth.

On the contrary, bad debt refers to money borrowed to buy something that starts loosing value as soon as it's in your hand, such as a car.

Using high interest rate cards to purchase disposable items – furniture, vacations, clothing etc. – may be considered bad debt if payment isn't made in full. This is because every month the amount is outstanding, you're charged interest. So, the cost of buying the items continues to increase while their value of the purchased items is decreasing – a double loss.

Debt principles to Live By

1. Your total monthly debt (including credit cards and mortgage) should be less than 36% of income before compulsory deductions (gross income).

2. Whatever item you buy through debt – both services and goods – should last longer than the repayment period of the debt.

  • For instance, fulfilling your childhood dream to witness the wild beast migration from Serengeti to Maasai Mara using your credit card is not a good debt because you will be repaying the loan long after returning from your exploration.

3. As far as possible, try and incur debts that build wealth over time.

· Illustration: Homes have proven to increase in value over time. Mortgage debts also provide tax deductions.


Types of Personal Debt

Personal debt is usually divided into five main categories; motor vehicle loans, education loans, installment loans, credit card debts, and other debts.

Motor vehicle loans, education loans, and installment loans are collective grouped under installment loans because they are often repaid with a fixed number of repayments of an agreed amount. On the contrary, credit card debts attract a minimum repayment (based on the balance) each month.

1. Motor vehicle loans

There are three ways of financing a motor vehicle purchase: leasing, paying upfront, or taking a loan to finance it. Because cars are expensive to purchase and many people wish to own at least one, most people end up taking a car loan (auto loan) to finance the purchase. In fact, according to a report by the National Transportation Statistics, an organization that presents United States transportation statistics, 2015, about 40 percent of all households have a motor car debt today compared to 25 percent a few decades ago.


2. Education loans

Huge education debt is not a new phenomenon. Reduced financial aid and government grants to schools and students have led to both an increase in the average amount of student loans and tuition fee. For instance, over the last one decade, education loan debt has doubled for people over thirty years, and almost doubled for people under thirty years.

Education debts are often considered an investment with capacity to produce future income to the borrower (student). However, due to the rising interest rates on these loans and stiff competition in the labor market, students might not reap financial benefits from them.

3. Installment loans

Installment debts are the oldest type of consumer loan. In the old days, they facilitated purchase of different services and goods from sewing machines to cars and vacations.

Installment loans are the only type of debt that has not been experiencing a lot of growth in the past few decades. This is because most of the goods and services which were previously purchased using installment loan are now bought using credit cards.

4. Credit cards

Credit cards are the most popular forms of payment in United State with the average household having four cards. A credit card debt should be paid in full every month to avoid interest.

Interest on credit card debt is always higher than interest charged on installment loan. In the year 2007, the average credit card interest was 15 percent more than the average interest rate on installment loans (7 percent).

Credit card interest rates rise over time, and they can rise exponentially if you miss a payment or exceed your card limit.

5. Other debt

Debts resulting from medical expenses, payday loans, as well as other miscellaneous debts like loans against life insurances and pensions are classified as other consumer debt. They include both non-installment and installment loans. These types of debts have almost tripled in the last two decades, rising from about $10,000 to $30,000.

The Concept of Tax Efficient and Inefficient Debt

Borrowed money or debt can play a vital role in helping you realize your lifestyle goals. However, it is critical to effectively manage and structure your debt to minimize the total borrowing cost. The way you manage your debt will depend on whether it's a tax efficient or inefficient debt.

1. Efficient Debt or Tax Deductible Debt

Efficient debt is a debt used to buy assets that generate income such as rental property or a portfolio of shares. In most cases, an efficient debt qualifies for a tax deduction depending on the interest cost.

2. Inefficient Debt or Non-tax Deductible

An inefficient debt is a loan taken out to buy assets or services which do not produce income such as a loan taken to purchase a personal car, a principal residence, or to finance a vacation. An inefficient debt does not qualify for tax deduction. Inefficient debts drain your ability to accumulate wealth. If possible, you should accelerate repayment of your nontax deductible debts.

The Pros and Cons of Debts

In general, with high income, credit history, credit score, and a low debt-to-income ratio, you will be approved for the full credit you are seeking. The lenders won't ask you why you require the loan or how you will use it unless you want a significantly high amount. Therefore, it is very easy to get a loan.

However, depending on how you manage your debt, a loan can either be a good thing that helps you to develop your life, or a nightmare that doesn't look like it's going to end anytime soon.

Debt finance can help you to;

  • Do minor fixes as well as upgrades to your residence

  • Take a dream vacation

  • Pay off other high-interest loans or credit card

  • Get your car repaired

  • Pay off medical costs and more.

If you are punctual in repaying your debt, you only pay the principal, interest rate, and maybe a loan closing fee, which is often included in the loan terms.

But just like everything else in our life, used the wrong way, debt have life-changing disadvantages that can leave a bitter taste in your mouth for decades. Consider the following;

  • Loans should be repaid on time – What if you do not have the cash to repay?

  • Loans attract interest and closing fees – These are included in your repayment amount but you don't personally consumer them. They constitute what is called the cost of borrowing.

  • If your loan attracts high interest rate, you might end up making zero returns on it.

  • Skyrocketing interest rates are making it harder to pay debts.

  • What if you lose your job? Will you manage to repay the loan? Note that in today's harsh world, it is almost impossible to pay a debt on unemployment payouts.

Therefore, you should think carefully before taking out a debt. Research and consult experts before agreeing to the terms and the conditions of a loan agreement.

As a rule of thumb, it's only wise to borrow to cover payments for stuff you really need or things that will generate future revenue.

For instance, although re-carpeting or repainting your home is never a bad thing, it makes more financial sense to take a loan to finance the renovation when the ultimate goal is to sell the house, not to make it cozier.


What if You Are Already Deep into Debts?

Accepting that you're undergoing financial difficulties and seeking professional help goes a long way in helping you solve your debt problems. Don't feel ashamed or embarrassed when disclosing your financial difficulties and debts to a professional. Ignoring your debt problems and failing to reply to a correspondence will worsen your financial situation. Most importantly, note that your financial problems won't end without remedial actions.

There are a lot of things you can do to resolve your debt problems.

  • Be calm and don't feel afraid or guilty despite facing threats. Instead, get support and advice to get through the situation.

  • Avoid the temptation to borrow more money so that you that you pay off your existing debts- Doing so will eventually create more problems.

  • Talk to creditors about your situation- Usually, they will respond sympathetically if your financial problems are genuine and you bring them to their attention.

  • Talk to your spouse and family. Share your financial or debt problems with your trusted spouse and family members so that you can work together towards getting a solution.

  • Talk to other agencies that can provide specialist advice- In most cases, these agencies will not charge you for their advice or services.

  • Contact the Citizens Advice Bureau in your local area. You can get more details about them from a telephone directory.

  • Usually, money problems lead to or arise from health, emotional pressures or health issues. It is therefore crucial that you reach out for professional help if you experience these problems.

  • Never despair- No matter how bad your situation seems, don't give up. Yes, the process of clearing debts is long, but the end results are worthwhile. The results will also enable you to regain control over your financial situation.


 
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