For a lot of South Africans, the term 'debt' make us immediately cringe or shudder - this is due mostly in part to the negative connotations attached to the word.
However, it is important that we gain a better understanding of debt and realise that it is not always something negative, that there are in fact many different types of loans and debts and that not all debts are created equally.
There are different types of debt
As we can gather, debts come in many shapes, forms and sizes and from a variety of places, however, all debt can be placed into one of four categories, namely: secured debt, unsecured debt, revolving debt and home loans. Allow us to elaborate some more on these categories.
Secured debt refers to a debt that is backed or conditional on the borrower providing a form of collateral in order to secure the loan - these loans usually have a reasonably lower interest rate than other loan types.
What this means is that should you fail to repay your debt, the lender can take possession and ownership of the collateral. For example, if you want to take out a loan to start a business and you leverage your car or home (an asset), against the loan to secure it, and should you fail to repay the loan the lender takes ownership of your assets.
Home loans are secured on the home you are purchasing and most car loans are secured on the vehicle being purchased. Some business loans may also be secured on business assets including fleet, invoices and property.
An unsecured debt operates oppositely to secured debts, in that it requires no collateral to be placed on the part of the borrower in order to secure the loan - these loans have a higher interest rate than secured loans.
The lender provides you with the line of credit based on good faith that you will repay the loan amount on time. For example, when you apply for a payday or short-term loan, the finance provider is not going to require you to provide security or collateral before they agree to give you the loan or line of credit.
Below we've listed some examples of unsecured loans but it is important to remember that some of these loan types may be secured.
Unsecured loan examples:
- Personal loans
- Credit cards
- Revolving loans
- Short-term loans
- Payday loans
- Quick and instant cash loans
- Bad credit loans
- Debt consolidation loans
Revolving or recurring debts
Revolving debts refer to the agreement between a lender and a borrower that allows the borrower to borrow a maximum amount, predetermined by the lender, on a recurring basis. The interest rates on these debts are usually very reasonable.
For example, credit cards and store account cards are prime examples of revolving credit - you as the borrower can max out your credit or account card every month provided the last month's purchases have been paid off.
A home loan or mortgage is possibly the largest debt many consumers can have. These loans are taken out with the intention of purchasing homes or renovating them.
This is usually a large loan amount, given to the borrower at a lower interest rate that is usually paid off over a period of 10 to 30 years and involve monthly repayments. An added bonus of this type of debt is that you can usually get a tax deduction because of them.
The tax reduction will be in the form of interest paid towards the purchase of the property.
Good debt versus bad debt
Once we understand the different categories of debt, it is important we realise that there is a difference between good debt versus bad debt.
This statement might arouse suspicion as to how can any debt be considered good, but in fact, the statement has merit - after all, how many people can afford the bigger ticket items such as cars or homes without a loan?
Ultimately, we can find a way to justify taking out a loan or spending on a credit card - however, realistically there are debts that are more worth it than others.
What are considered good debts?
The general rule of thumb with good debt is that it helps you increase your net worth or helps you generate income. These things would include;
- Student loans -there is a positive correlation between higher income and higher education.
- Home loans - property is an asset that adds to your net worth and you can make money out of boarders or renting out a property - the property also tends to increase in value.
- Business loans - taking out a loan to start a business creates an opportunity for you to grow your income and net worth.
What are bad debts?
As opposed to good debt, bad debts involve you taking on debts for things that do not add value (net worth growth or raised income) instead they depreciate in value. These things would include;
- Cars - although it is lovely to have your own transport, unless you are using your car to make money it is not a good investment.
- Clothes and other consumables - even though we need to wear clothes and eat food, more often than not we are being horribly ripped off and pay much more than what the products are worth. The interest we pay on these items is money wasted that could have been used for something else.
- Credit cards - possibly the most common debt, credit cards are easy to overuse and come with very high-interest rates.
Although these are just some guidelines to help you better understand debt, in the end, a lot of what we have spoken about is dependent on the individual person's financial situation and circumstances. What one person may consider an investment, another may consider a waste - in the end, it is all up to your own personal standards.