Explained: All You Need to Know About Debt

We have all encountered debt at some point in our lives, either in the form of borrowing money from a friend, or taking a loan from a bank. A lot of financial studies show that debt is the number one cause for financial trouble. With so many exciting offers on credit cards and competitive interest rates on loans, it’s tempting to choose ‘debt’ in a vulnerable financial situation, and then fall prey to it’s vicious cycle. Not all debts are bad.

If you choose to take a loan when it’s absolutely necessary and are well aware that you will be able to repay it, it’s a win-win for both you and the financial institution. However, some of us opt to get into debts, just to solve a temporary situation and then feel trapped when we’re unable to repay and aren’t able to do all the things we want to, with our money.

In some cases, the emotional distress outweighs the financial consequences. Over time, the constant pressure of debt can also damage your mental state, work, health, and relationships.

So let’s understand the meaning of debt, different types of debts, and why we should avoid it at all costs.

What is Debt?

Debt is the amount of money borrowed by one party, from another. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest. In simple words, debt is money borrowed from another party, for something you can’t afford.

Now let’s talk about the types of debts, so we know what debts to avoid, the next time we feel like borrowing money.

Types of Debt

Secured Debt

Secured debt is a type of debt backed by another asset or any form of guarantee for the purpose of collateral. It often involves a credit check by the lending organization to evaluate credit history. This collateral is handed or pledged to the lender in case the borrower fails to pay back the loan. An instance of such debt is if you take a loan to buy a car, the lender provides you with the cash to make the purchase. If you fail to repay the loan, the lender can take possession of the car and sell it to recover the funds. Secured loans have relatively lower interest rates depending on the value of the collateral.

Unsecured Debt

Unsecured debts are taken in the absence of any collateral. Such loans have an added risk component as it may not be recovered at all. The lender can take legal action to reclaim the sum of money owed. Due to the high-risk component, these loans have relatively higher interest rates.

The most important consideration when buying on credit or taking out a loan is whether the debt incurred is good debt or bad debt.

Good Debt

Good debt is an investment that will grow in value or generate long-term income. Taking out student loans to pay for a college education is the perfect example of good debt. First of all, student loans typically have a very low interest rate compared to other types of debt. Secondly, a college education increases your value as an employee and raises your potential future income.

Bad Debt

Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also debt that carries a high interest rate, like credit card debt. The general rule to avoid bad debt is: If you can't afford it and you don't need it, don't buy it.

What Are the Benefits of Debt?

There are many financial benefits to reap, simply by avoiding bad debts. Here are some of them:

More Free Income

When you’re carrying a lot of debt, the payments on that debt tie up a big chunk of your income. If you can find a way to pay off that debt early, you’ll have extra money from your income available every month, for you to be able to use it for the things you really want to.

More Room for Investments

Another thing to do with the extra money you save by paying off your debt, is to put it into investments. If you’re not putting enough into your retirement accounts right now, that extra cash could mean the difference between retiring at 65 or having to work into your golden years. And, if you’re already maxing out your retirement contributions, putting the money into other investments could help you reach financial independence and be able to stop working even earlier.

Less Risk

One of the worst things about being in debt is the risk it brings into your life. If you’re already in debt and have no emergency savings to fall back on, you’re always just one financial blow away from disaster.

A Better Credit Score

Carrying a lot of debt really weighs down your credit rating. The closer your credit cards and loans are to the limit, the lower your score will be. A bad credit score can cost you a lot of money in the form of high interest rates, making it harder to escape from your debt trap.

There’s a lid on the amount of debt you can comfortably take on, tied to your income. Too much, and you’ll quickly find yourself in a bind. And even if your debt load is low, remember: there may be better ways to use that money. No matter how much debt you’re carrying right now, pay it down — and then once it’s gone, take those payments and start directing them towards your savings.

Freeing yourself from debt can make your life better in just about every way. So before you borrow money the next time, think again.