Don’t fret about debt: the basics of borrowing

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Almost everyone needs to borrow money at some point in their lives — it could be to buy a car or house, to pay for education or to cover an unexpected expense.

This might seem scary — after all, borrowing sometimes has a bad reputation. “Neither a borrower nor a lender be,” is a famous line from Shakespeare’s play, Hamlet. And some religions object to the practice of charging interest on borrowed money.

But there are good and bad types of borrowing. Financial advisers talk about the concept of “good debt” — borrowing that helps increase your income or build wealth. This might be a loan to further your education or a mortgage to buy a home.

Where borrowing can be bad for your finances is when you take out a large loan that you cannot afford, or one with high interest payments.

Also, think carefully if a friend or family member offers to lend you money. If you struggle to pay them back, or they put pressure on you to pay them back early, it could damage your relationship with them.

Before borrowing any money, you should always be very clear about what you need it for; how much you need; when you need it; and how you are going to pay it back. This will help you work out the best route to go down.

Types of borrowing

Overdrafts

If you only need to borrow a small amount of money for a short period of time, you could use an arranged overdraft with your bank. This is a pre-agreed limit on your current account that allows you to spend more than your balance. Arranged overdrafts often have higher fees and charges than other borrowing options but they can be a good way to cover emergency spending or an unexpected bill for a short period of time.

Credit cards

With a credit card you borrow by spending on the card up to an agreed limit. If you pay off the total amount spent on the card each month, you will not be charged interest. But if you don’t pay it off, you may be charged interest on the amount you owe.

The amount of interest charges varies between credit card providers, but it can be quite high. Always try to pay at least 10 per cent of your balance every month on your credit cards. If you only pay the minimum amount it will take a long time to pay the debt off.

Some credit cards offer a balance transfer, which allows you to move the balance from one card to another. This could help you get a cheaper interest rate.

Some shops have their own types of credit accounts known as store cards, which may offer discounts on goods purchased there. But the interest charged is often higher than on bank loans or credit cards.

Personal loans

With a personal loan from a bank or other regulated lender, you usually borrow a fixed amount up front. This is then repayable in monthly instalments over an agreed period of time.

Usually, the interest rate is fixed for the agreed period but some loans have variable rates that go up and down. If you don’t make the repayments on time, you may have to pay a fee.

Watch out for unregulated lenders, who are sometimes called loan sharks. They may use harassment and violence to collect debts. Loan sharks are illegal in the UK, where lending money without authorisation from the Financial Conduct Authority is a criminal offence.

Student loans

Some countries have special borrowing arrangements to pay for education, which typically offer more attractive rates than commercial loans. The US, for example, provides a range of income-linked government-backed grants and low interest loans; the UK also operates a loan programme with repayments linked to future earnings. 

Mortgages

A mortgage is a loan taken out from a bank or building society specifically to buy a flat or house. The amount you can borrow is usually based on the amount you earn, or your ability to pay it back. You might have to give the lender an estimate of your monthly income and spending before they will agree to lend the money.

The term of the mortgage is usually very long, typically 25 years or 30 years, and you pay it back by monthly instalments. Importantly, you agree to give the property as security, which means if you don’t keep up with the repayments, the lender can take ownership of it.

There are two types of mortgage. With a repayment mortgage, your monthly payment is used to pay off both the amount you originally borrowed (the capital) and the interest, so that the whole loan is paid off by the end of the mortgage. With an interest only mortgage, your monthly payment goes towards paying the interest on the loan only. At the end of the mortgage term you will have to repay the capital from savings or investments.

Check the rates

On all types of borrowing, the interest rate is very important so spend some time shopping around for a good deal.

The key term to look for is APR, or Annual Percentage Rate. This shows the amount of interest, including management charges or fees, that you’ll pay on the money borrowed during one year. It’s shown as a percentage. The higher the APR, the more you’ll pay.

If you have a lot of different types of borrowing set up, always try to pay off the one with the highest level of interest first.