Personal Debt Explained for Dummies

What is debt?

Simply put, debt refers to money borrowed by one entity from another entity to cover a financial need that cannot otherwise be covered immediately or in full.

Put in other words, debt is money owed by one entity and due to another entity.

An entity can include, amongst others, a person, business, corporation, organisation, or government.

Furthermore, the following definitions are useful to comprehend more of the essence of debt.

• The Cambridge Dictionary defines debt as ‘something, especially money, that is owed to someone else, or the state of owing something.’[1]
• According to the Merriam Webster Dictionary, debt is ‘a state of being under obligation to pay or repay someone or something in return for something received: a state of owing.’
• com describes debt as ‘something that is owed or that one is bound to pay or perform for another.’
• Wikipedia’s definition of debt is quite comprehensive: ‘Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase.’

Noteworthy, the term ‘debt’ originates from an old French word ‘dette’, meaning an obligation.

Types of debt

The focus of this article is personal debt, implying that debt obtained by businesses, corporations, organisations, and governments is excluded for the purpose of the article.

Basically, there are four types of debt, namely secured debt, unsecured debt, revolving debt, and mortgage bonds.

Secured debt

Secured debt, also referred to as collateralized debt, requires a borrower to pledge a valuable asset, (or assets) with a value large enough to cover the amount of the debt.

Examples of assets that can serve as collateral include property, houses, vehicles, securities, and other types of investments. Hence, common secured loans comprise, inter alia, vehicle loans, and mortgages, because the item financed is the collateral.

If a borrower defaults, the collateral can be sold to recoup the outstanding debt amount. However, a borrower can still owe money after this process if the returns from the sale of the asset does not cover the outstanding loan balance in full.

Typically, a prospective borrower has to go through a vetting process, verifying his or her creditworthiness to determine whether he or she qualifies for a secured loan.

Furthermore, the borrower’s level of income and employment status will be confirmed, and the value of the collateral will be assessed.

Unsecured debt

Contrary to secured debt, unsecured debt does not require collateral as security from a borrower.

Therefore, it is important for a lender to review and check, inter alia, the following aspects with regard to a prospective borrower:

• Creditworthiness, meaning obtaining information about a person’s credit record (credit profile) to determine the extent to which an individual is considered reliable and trustworthy to repay his or her loan.
• Monthly earnings, either as an employee or as a business owner.
• Financial status, amongst other indicators, is how much liquid cash is available.

Student loans, personal loans, bank overdrafts, and credit cards are examples of unsecured debt.

Although a lender does not have collateral available to recover the outstanding debt, there are other remedies at his or her disposal, such as:

• Letter of demand, requesting the borrower to perform according to the loan agreement.
• Reporting unpaid debt to a credit bureau, which will negatively affect a borrower’s credit record.
• If all else fails, obtaining a garnishee order (GO) from a Magistrate’s Court. Legal Wise describes a garnishee order (GO) as follows: ‘A GO is an order by a Magistrates Court, whereby the creditor attaches a portion of a debt owed to the debtor by a third party (“garnishee”). The garnishee will deduct part of the debt or pay all of the debt, due to the debtor, directly to the creditor.’

For example, if person IO You fails to repay R500 per month on a loan from bank ABC, the bank can obtain a garnishee order, requiring the employer of IO You to deduct R500 per month from IO You’s salary and pay it directly to bank ABC.

Revolving debt

Revolving debt is a type of credit in which an amount of credit is offered to a client by a financial institution, such as a bank, limited to a maximum amount.

The client (borrower) has access to the full amount and can use the full amount or portions of it.

Credit card debt is a good example of revolving debt. Features of credit card debt are, amongst others:

• The credit card holder is allowed a certain credit limit.
• The holder is obliged to make a minimum monthly payment, typically a certain percentage of the outstanding amount. The percentage can differ from lender to lender, usually between 1% – 10%.
• With a favourable credit history, the cardholder may request the bank to increase the credit limit, subject to the normal credit conditions of the bank.
• Interest and card fees are payable monthly. Typically, interest on credit cards is exceptionally high in comparison to other types of credit.

Mortgage bonds

According to some consultants and advisers, mortgage bonds, commonly called mortgages, are so unique that they justify their own debt categorisation.

A mortgage is a type of secured debt issued to a borrower to buy real estate such as a residential property like a house. A borrower can also obtain a mortgage to buy other types of real estate such as commercial and industrial property, or land.

A mortgage bond also referred to as a mortgage loan, is a legal agreement (called the mortgage bond agreement) by which a home buyer transfers his or her property rights over the home to the loan provider in order to secure the home loan.

Put differently, the mortgage bond agreement stipulates that the home buyer pledges the home as security in order to obtain the home loan. This means that the loan provider (bank) is allowed to repossess the home if the borrower defaults on the home loan.

The mortgage bond and home loan do not have to be of the same amount. However, the mortgage amount cannot be less than the home loan it secures.

Typically, mortgages are paid off in monthly instalments over long periods, between 15 – 30 years.

Terms associated with a mortgage:

• Collateral: The property pledged as security for repayment of the home loan.
• Mortgageable property: The home is used as security (collateral) to obtain a home loan.
• Mortgagee: Refers to the lender (for example, a bank) who lends money to a borrower.
• Mortgager: Refers to the person or entity who borrows money in order to buy a home (property).

Good debt versus bad debt

These days, it is almost impossible to live without debt. Most ordinary people cannot afford to pay cash for items such as homes, vehicles, or tertiary education and are compelled to apply for debt to achieve certain goals.

Hence, debt plays an important role in an individual’s or family’s budget.

Although, if applying for debt, a person must approach the transaction with prudence – convinced and ensured that debt is the only way to get certain things done.

It will also be wise to keep the following saying of Josh Billings (American humorist, 1818 – 1885) in mind: ‘Debt is like any other trap, easy enough to get into, but hard to get out of.’ Without a doubt, a true word spoken in jest.

Another sobering fact to be aware of is that debt can be either good or bad, based on the effect it has on a borrower’s finances and life.

What is good debt?

Good debt, sometimes referred to as ‘credit that works for you,’ is money borrowed that has long-term value, enabling a person to improve his/her net worth and generate income over a period of time.

Examples of good debt are:

• Loans for tertiary education. However, not all tertiary education is of equal value. Therefore, make sure that a degree or diploma will support a student when applying for employment.
• Business loans to start or expand your own business.
• Mortgages – See above under ‘Mortgage bonds.’

What is bad debt?

Bad debt, sometimes called ‘credit that works against you,’ refers to credit card debt and other consumer debt that do little to improve a borrower’s financial position.

Furthermore, it is bad debt when money is borrowed to repay other loans.

Are vehicle loans (auto loans) good or bad?

It depends on the situation and circumstances.

A vehicle loan can be defined as bad debt when a loan is obtained to by a certain type of vehicle, only to try and ‘keep up with the Joneses.’

Contrarily, a vehicle loan might be considered good debt when it is essential to own a vehicle to travel to work or doing business as a business owner.

However, remember, unlike property such as homes, vehicles depreciate (losing value) over time. The influential American author, Orrin Woodward, is adamant about debt that is used to buy things that depreciate, saying: ‘Debt on anything that depreciates is disastrous.’

Interest on debt – The cost of money

Acquiring debt involves interest, also referred to as the cost of money. Differently put, interest is the cost associated with the money borrowed from another party, such as a financial institution (like a bank) or an individual.

Interest on debt is calculated as a percentage of the initial amount of debt provided, also called the principal or capital amount.

Typically, the interest rate is quoted as an annual rate, the rate of interest charged to borrowers.

Although, interest can also be calculated for periods longer or shorter than a year, such as a quarter.

When a borrower has a good credit score and is considered a low credit risk, the borrower will usually be charged a lower interest rate and vice versa. (A low credit risk implies that a borrower will rarely default on his or her debt obligations.)

An interest rate can either be:

• A floating interest rate, meaning that the rate changes in relation to another benchmark interest rate. For example, in South Africa, floating interest rates change when the South African Reserve Bank (SARB) changes its repo rate for banks.

Or,

• A fixed interest rate, implying that the rate remains the same during the period a loan is granted to a borrower.

Basically, there are two types of interest, namely simple interest, and compound interest.

• Simple interest

Simple interest, also called flat-rate interest or non-compounding interest, is calculated on the principal amount of a loan over a specific period of time. The principal amount remains the same during the term of the loan.

The formula for the calculation of simple interest is:

Simple interest = P x r x t

Where:

• P = Principal amount
• r = Interest rate
• t = Number of specific time periods, such as a year or month

In order to calculate simple interest, it is required that the time period must reflect the same time frame as the interest rate. For example, if the interest is indicated as an annual rate, then the number of time periods must also be indicated in years. For instance, if the annual interest rate is 5% and the time period is 60 months, then the period will be indicated as 5 years in the calculation.

Similarly, if the interest rate is indicated as 10% per year, but a semi-annually (every six months) interest rate is required, then the semi-annual interest rate is 5% (10% divided by 2).

Example of simple interest: Clarise borrows R500 000 from bank QED at a simple interest rate of 9% per year for a period of 3 years. This will translate into a yearly interest payment of R45 000 (R500 00 x 0.09). The total amount of interest for the 3 years will be R135 000 (R500 000 x 0.09 x 3).

In the calculation, the interest rate of 9% was converted to its decimal form (0.09) by dividing it by 100.

• Compound interest

Compound interest, also known as interest on interest, is applicable when interest is charged monthly on the sum of the principal (capital) amount and the accumulated interest from the previous periods.

For example Zané borrows R500 000 from bank HOH at a compound interest rate of 8% per annum for a period of 5 years. If no repayments are made during the five years, the calculation of Zané’s compound interest will look as follows.

A comparison between compound interest and simple interest in the example above shows that compound interest is R34 664 more than simple interest over the period of five years.

Albert Einstein clearly understood the effect and power of compound interest when he famously said: ‘Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pay it.’ (Accentuation by article writer).

[1] Accentuations in quotations from sources are by the article writer.