Topic 5 – Good Debt, Bad Debt

What is borrowing?
Borrowing means drawing from future income flows to finance an item of expenditure now. Someone who has borrowed money is in debt to the lender; this is a legal relationship and arrangements
must be made to pay back the debt plus interest.

The benefits of borrowing The costs of borrowing Attitudes to borrowing and debt Balancing the benefits and costs of
debt
Borrowing can help people to smooth out When someone borrows money, they Many people see borrowing as a normal
Someone who is considering financing
differences in timing between their income agree to repay the debt from their future thing to do and financial institutions
expenditure with a loan should take both
and expenditure. Someone who is always income. This means that they will have compete for the opportunity to lend to
the benefits and costs of borrowing into
short of funds at the end of the month can less left over from their future earnings people. Customers can shop around and
account:
use their credit card or overdraft to finance until they have repaid their loans and so get the best deal to suit their needs.
◆ The advantages and disadvantages of
their purchases until the next salary there is an opportunity cost, ie the value Young people are more likely to have to
each individual loan should be
payment arrives in their bank account. A of the best alternative purchase that borrow when they are starting out in
considered not only independently, but
negative balance at the end of the month – they could have made with this money. adult life than older people who have
also in light of any other loans that the
the result of spending more than your Borrowing is a product that must be paid been working for some years. Younger
prospective borrower might already have
monthly income – is a deficit. Borrowing for; the cost is called ‘interest’. A people will need loans to finance their
taken out. Prospective borrowers should
money to cover this deficit is sensible if borrower repays not only what was studies, day-to-day cash flow and the
look at their overall debt situation and
you know that you will have extra money borrowed, but also a percentage interest larger items of expenditure. In recent
not only at each loan separately.
next month to repay it. But if you have to charge on top of this to recompense the years, there have been a lot of reports in
◆ The price that the customer pays for a
carry the deficit over to the following lender for the use of its money over the the media about people who have not
loan must be reasonable when
month and add to it to cover that month’s time of the loan and for the risk that it used their borrowing facilities wisely and
compared
deficit, you will be in danger of takes (that the borrower will default). now have too much debt. Providers have
with the purpose of the loan: are the
accumulating a rising debt – money that Some types of debt (such as payday also been guilty of irresponsible lending
items purchased worth the amount of
you have borrowed, but which you cannot loans) are very expensive, while others – of providing credit too easily and
interest being paid and could the money
afford to pay back. Most people borrow (such as personal loans) are much lending money to people who could not
have been borrowed more cheaply
money as a means of affording a cheaper – and mortgages offer the afford to pay it back (see Topic 3). This
elsewhere?
substantial purchase, such as a house, a lowest rates because they are secured was one of the factors that led to the
◆ The length of the loan should also
car or furniture, which they need to buy on the property. 2007–08 financial crisis, and to several
correspond to the life of the article
now, but which is too expensive to be banks and other institutions in a number
purchased. For example, the borrower
funded only by current income. It might Defaulting on a loan of countries ceasing to trade or needing
will sensibly apply for a 25-year loan to
take someone too long to save up for an government help to survive. This
Defaulting on a loan is a serious matter. fund the purchase of a new home – but
item that they need immediately or very financial crisis was followed by a
◆ If the loan is secured on an asset, such not to finance the purchase of a
soon; if they buy the item now with recession, during which many people
as a mortgage secured on a home, the computer.
borrowed money, they can use it while lost their jobs – and the impact of
borrower will lose that asset – their home Whether or not an individual decides to
they repay the loan. The most common becoming unemployed and losing your
– if they stop meeting the repayments. If borrow also naturally depends on their
example is the mortgage loan: very few income is even worse if you already owe
the borrowing is in the form of a hire attitude to debt and to risk – and
people are able to buy a house without money. The numbers of house
purchase agreement, the borrower will remember that the cultural group(s) to
taking out a mortgage loan, which they
lose the goods – and will not be able to repossessions and of mortgage arrears which they belong and their ethical
pay back while they are living in the house.
recoup the payments already made. increased considerably after 2007, values are likely to have shaped these
Although they will pay interest on the loan,
◆ If the loan is unsecured, the defaulter according to the Council of Mortgage attitudes People borrow only to the
interest rates are lower for a mortgage
will obtain a bad financial reputation Lenders (CML). Some 46,000 homes extent with which they feel comfortable.
than for other loans because it is secured
or ‘financial footprint’, which means that were repossessed in 2009 – the highest To maintain sustainable personal
on the property. This means that there is
they may be unable to get credit again number since 1995. During the third finances, then, an individual’s borrowing
less risk for the lender, as it can sell the
In the worst case, the person could be quarter of 2017, however, only 1,300 decisions should not be taken in
property to recover its losses in the event
declared bankrupt. mortgaged properties were repossessed, isolation, but should be both integrated
that the borrower defaults on the loan (ie
which was the lowest repossession rate into their short-term and medium-term
cannot afford to maintain their
on record. The number of mortgages in budgeting plans and cash-flow forecasts
repayments).
arrears also hit a ten-year high of and fully justified as part of their long-
196,000 in 2009, before falling to term financial plan.
169,600 in 2010.
Informal Payment Plans
Borrowing and financial footprints If the debtor’s income is enough to leave
 Topic 5 – Good Debt, Bad Debt
What is borrowing?
Borrowing means drawing from future income flows to finance an item of expenditure now. Someone who has borrowed money is in debt to the lender; this is a legal relationship and arrangements
must be made to pay back the debt plus interest.
When a potential borrower approaches a a surplus after paying priority bills and Administration Orders & CCJs Debt Relief Order (DRO)
bank or finance company for a loan, the their essential spending (eg on food,
The structure of an administration order If the debtor has quite a low level of debt
lender researches their credit history. drink and household goods), the debtor
is similar to that of a DMP, but in this (ie total unsecured debt of less than
There are three large credit reference should then use this surplus to offer
case the debtor pays the single monthly £20,000), low surplus income (no more
agencies regular repayments on the remaining
payment to the court rather than to a than £50 per month after paying normal
in the UK: nonpriority, unsecured debts,
DMP manager. Likewise, the CCJ household expenses) and few or no
◆ Experian; negotiating lower monthly payments
represents a legally binding requirement assets (no more than £300), a DRO is an
◆ Equifax spread over a longer repayment term.
to pay what the court has decided is alternative to an IVA or bankruptcy. Debt
◆ TransUnion The debtor should contact the banks and
owing, either in full or by instalments, by relief orders offer a route towards being
These companies compile files on credit card companies to which they owe
a certain deadline. That payment may be free of debt that is quicker and easier
consumers using information from banks, money (on outstanding loans, overdrafts,
made to the court or directly to the than IVAs or bankruptcy, because the
building societies and credit card credit card balances, etc), and explain
creditor. Administration orders and CCJs debtor can simply apply online using one
companies, and also from county court the situation and what payments they
both incur court fees, payable by the of the four authorised free debt advice
judgments (CCJs), the electoral register, can afford to make. A creditor will
debtor, but these can be added to the agencies (StepChange Debt Charity;
bankruptcy orders and house usually agree to accept a reduced
total debt and included in the debtor’s National Debtline; Payplan; Debt Advice
repossessions. The details of every loan, monthly payment, and to stop charging
monthly repayment. Foundation). The agency will then
credit card or other credit agreement that interest and missed payment fees, if it
forward the application to the court’s
an individual has or has had are recorded sees evidence of a regular income and
Individual voluntary arrangement Official Receiver, who will decide
in these files, which builds up a picture of no spending on non-essential ‘luxuries’.
(IVA) whether or not to make an order. There
how much the individual has borrowed and The monthly amount that the debtor
This is a formal agreement between is an administration fee for DROs that
how good they are at making the required negotiates with each creditor should be
debtor and creditors; creditors can be paid in instalments.
monthly payments. The credit reference in proportion to the size of the total debt,
agencies themselves do not make so that all the creditors are fairly treated representing at least 75 per cent of the
decisions on whether or not customers and the debts are all repaid over the total debt value have to agree to the Bankruptcy
should be granted a loan and they do not same time period. arrangement for it to become legally
A debtor might not able to use an IVA –
keep a ‘blacklist’; they simply supply binding. It is set up and supervised by a
perhaps because their surplus income is
information to lenders on request. Every licensed insolvency practitioner (IP), ie a
Debt Management Plan not enough to support an acceptable
time a person applies for a borrowing firm of accountants or solicitors who will
monthly repayment, or because they
product, the lender will search the credit Anyone who does not feel capable of examine the debtor’s finances – income,
have tried to set up an IVA, but the
file, and this search leaves an electronic making all these arrangements by expenditure and assets (what they own)
insolvency practitioner (IP) has failed to
‘footprint’ in the person’s personal credit themselves can get free help to set up – and decide how much they must pay
get the required 75 per cent creditor
history. If they apply for an unusually large and maintain a more formal DMP. They into the IVA each month (typically at
support, or they have agreed an IVA, but
number of loans, a note is put on their will contact the debtor’s creditors and least £200) for a fixed period (usually
then defaulted on their monthly
record. ‘Shopping around’ for the best loan agree affordable monthly payments to five years). The creditors will often agree
repayments. In these circumstances, the
or mortgage deal can also cause a each creditor. The debtor then sets up a to an IVA only if the payments that they
debtor may be forced into bankruptcy.
problem, because lenders may view single monthly payment to the DMP receive amount to at least 30 per cent of
Any creditor who is owed at least £5,000
multiple credit searches by different credit manager, who passes it on to the the money owed (and some insist on
on an unsecured loan can also ask the
providers as a sign that the individual is creditors in the agreed amounts. DMP’s repayment of 40 per cent or 50 per
court to declare a debtor bankrupt, or an
finding it hard to get a loan agreed. Making are provided by Stepchange, National cent). If the debtor makes the monthly
individual struggling to pay back
payments late or missing payments, Debtline, Payplan and Debt Advice repayments for the full term of the IVA,
unsecured debts can apply to the court
building up payment arrears and Foundation. their debts are then classed as
themselves for voluntary bankruptcy.
defaulting on a loan credit agreement (ie ‘discharged’ and they are officially ‘debt-
failing to pay it all back) all show up as free’ as far as unsecured debts are
negative footprints on a person’s record. concerned.