A loan can be a great tool, but also a dangerous enemy. It is a big decision that everyone should think through properly.
Of course, a loan can help you in many ways. It can help you buy a home, so instead of paying rent to a landlord you are paying off your own place. It can help you start the business you have always dreamed of. It can also be a lifesaver when something goes wrong, although your emergency fund should always be your first safety net.
However, debt is also behind many difficult life situations. People with lower incomes are sometimes forced to borrow and can fall into a debt spiral. A bad credit history means getting the worst deals, and getting out of that situation is hard. Use loans as a good servant, and avoid borrowing for vacations or everyday consumer goods.
What is debt?
Debt is borrowed money that lets you make bigger purchases than you could otherwise afford. You pay it back later, with interest and sometimes fees on top. Most of us know that much, but there is a lot more behind the curtain, and the topic gets complicated quickly. Below we explain the basic terms you will come across when it comes to types of debt and how to manage it.
Different types of loans
Need to borrow money? First, figure out which type of loan suits your situation. Here are some common ones:
Mortgage
If you are buying or refinancing a home, this is the loan for you. For most people, a home is their most valuable asset, so they take on this long-term loan. Repayment periods of 25 to 30 years are common, though they vary by country and lender. Mortgages are not easy to get. Lenders look closely at your credit history, savings and type of employment. Depending on where you live, there are different rules on how much you can borrow, the maximum monthly payment and the minimum down payment. Our mortgage calculator shows what a loan would cost you each month.
Buy now, pay later
Buy now, pay later services let you get your order now and pay for it later, often in a few installments or within a month. Used carefully, this can help with an unexpected expense before your next paycheck. But it is easy to lose track of several plans at once, and late payments can bring fees. We always recommend having an emergency fund for situations like this, so you don’t have to borrow the moment something goes wrong.
Credit card
A credit card lets you pay with the lender’s money. The lender sets the interest rate and your credit limit. There is usually a grace period when you can repay without interest. After that, the interest is usually high, so make sure you can pay the balance back in time. Credit cards are useful, but they can get out of hand if you use them without a plan. Before a shopping spree, know the pros and cons: credit cards make overspending easy and can lead to more debt if handled carelessly. On the other hand, in many countries they help you build a credit history and can be a backup for emergencies.
Business loan
Not all debt is bad. Without it, many great opportunities for growth and new ideas would be missed. For example, a business loan can help you start your own company, earn money and repay the debt. It can pay off, but there is always a risk of ending up with a failed business and a loan to repay.
Student loan
Student loans usually pay for higher education, such as university or college. Unlike scholarships or grants, they have to be paid back, often with interest. How student loans work, and how much they cost, differs a lot from country to country. Repaying them can take many years, but a degree can also open the door to better jobs and higher pay.
Leasing
Leasing comes in many forms. The most common is renting an asset, such as a car, that the leasing company owns. If you need a car, you can lease one instead of buying it outright. At the end of the lease, you return the car or buy it by paying its remaining value. You don’t own the car during the lease, but it can still be a sensible way to get one.
Key terms to know
To help you find your way around the topic, here are some commonly used terms:
Credit score
Your credit history builds your credit score. It reflects things like how much you owe, what types of accounts you have, how old they are and whether you have paid late. It should show how responsibly you repay debt. A higher score makes you look better to lenders. Not every country uses credit scores, but most have something similar, like a register of debtors.
Interest
When you borrow money, paying back the original amount isn’t enough. Interest is a percentage charged on the amount you borrow, and it is how the lender makes money. Some predatory lenders charge extremely high interest and target people with poor credit who can’t borrow anywhere else. Be careful and only borrow from reputable lenders.
Liability
A liability is something you owe and haven’t paid yet, such as a bank loan, a mortgage, taxes due or unpaid invoices. Liability is a broader term, and debt is one type of it.
Consolidation
Debt consolidation lets you merge several debts into one loan with one monthly payment. If you are juggling many repayments each month, it might be worth a look. You can often get better terms, like a lower interest rate or smaller monthly payments. Read more in our guide to debt consolidation.
Refinancing
Refinancing is similar to consolidation, but it usually means replacing a single debt with one on better terms, such as a lower interest rate or smaller monthly payments.
Bankruptcy
Bankruptcy is a legal process for people or companies who can’t pay their debts. You may be declared bankrupt when your situation is unlikely to improve and there is little hope of repaying. Your belongings can be assessed and used to repay creditors, and even then you may not be free of all your debts. Afterwards, it is usually hard to get a larger loan for years. The key to recovering is rebuilding your credit history and using your income very carefully. The rules differ a lot between countries.
Repayments
Repayments are the regular installments you pay to return the borrowed money. Understanding how your repayments work and having a plan is key to good financial health. The repayment period depends on the loan. A mortgage usually takes decades, while a car loan can be repaid in a few years.
Principal
The principal is the amount you originally borrow. Your total debt is the principal plus the interest that builds up on it.
Debt relief programs
Debt relief or debt management programs aim to help you pay off debts more easily. Some are run by reputable nonprofit counselors, but others charge high fees or can hurt your credit. Check who runs a program and what it costs before you sign up.
We hope this article helped you understand debt a little better.