This blog explores the differences between debt and credit.
It also addresses some key concepts that arise when exploring your options in personal finance.
Definitions
Here are some brief definitions of debt and credit.
Debt
Debt is money that needs to be repaid to a person, organisation or institution. It is the result of borrowing.
Debt typically has an interest rate, as the lender takes a risk.
Money decreases in value over time, making it more valuable now than in the future (the time value of money).
Additionally, lenders require an incentive to take on the risk of lending money.
For instance, if you spend £400 on a credit card, that is £400 worth of debt.
Credit
Credit refers to your ability to acquire debt.
In other words, it is the amount of money you can borrow or your potential borrowing capacity.
Many factors affect the amount of credit available to you.
If someone has good credit, they can borrow more at a lower interest, as the lender takes less risk.
If someone has bad credit they can borrow less at a higher interest rate, as the lender is taking more risk in lending.
For example, your spending limit on your credit card might be £4000.
Good Debt vs Bad Debt
A common dichotomy in financial spaces is the idea of good and bad debt.
First and foremost, you could argue that all debt is bad and potentially immoral.
Certain religious groups are against lending, or borrowing money when there is an interest rate on top of the original amount (principle).
Usury
This practice of lending money with added interest is called usury, or riba (in Islamic law).
In modern times this refers to the practice of lending money at unreasonably high interest rates.
Historically, it was defined as charging any interest on loans, but modern definitions typically focus on excessively high rates that exploit borrowers.
Usury laws vary by jurisdiction and are designed to protect consumers from predatory lending practices by setting legal limits on the maximum interest rates that can be charged.
These laws aim to prevent lenders from taking unfair advantage of borrowers who may be in desperate financial situations.
Islamic banking attempts to circumvent this restriction through the practice of murabaha.
Essentially, if someone attempts to pay for an asset, the asset is marked up in price and divided into split payments. It may amount to similar payments, but I think it avoids some of the pitfalls of interest rates (especially in the UK).
Some of the Muslims that I know are divided on what amounts to usury, so the issue of debt is complex from the point of view of scripture.
Bad Debt
Bad debt is essentially debt that is taken on that does not create an investment return.
There are various forms of “bad debt”, and I think it is quite possible to rank them in terms of their danger.
Bear in mind however that many factors determine just how dangerous debt can be and different circumstances have to be taken into account:
- Loans from a Loan Shark: Losing body parts or your life is not worth the risk.
- Payday Loans: Payday loans often carry extremely high interest rates as they are originated by people who cannot afford payments, and do not solve your income problem. Please get an emergency fund together to avoid taking these out!
- Personal Loan: Personal loans often carry relatively high interest rates, sometimes prepayment penalties, but can be used to consolidate high-interest debts.
- Credit Card Debt: Credit cards can sometimes come with extremely high interest rates, so can mount up when balances are not paid. Credit cards, however, have many benefits when utilised correctly.
- Auto Loans: (relatively high interest rates on a depreciating asset, however, a vehicle may help you make more money long-term)
Good Debt
Good debt is generally seen as debt that can create an investment return.
This can include:
- Student Loans: These can be considered good debt if the education leads to high earnings. It is, however, getting more difficult to justify student loans, and many degrees do not deliver a return on investment financially.
- Mortgages: Buying property can be a good investment if property values appreciate over time. Mortgages are secured loans as they are tied to the house (this is why banks generally like them).
- Business Loans: Borrowing to invest in a business can lead to growth and higher profits. Remember, however, how difficult it can be to run a business and be aware of the high likelihood of failure.
Note: If payments cannot be serviced, all debt could be considered “bad”.
7 Steps to Improve Your Credit Score
Improving your credit score is essential for better financial opportunities.
I’ve done all of these steps to get my Experian Credit score above 900.
Here are key steps to enhance your credit health:
Review Your Credit Report
- Obtain your free credit report from Experian, Equifax, and TransUnion.
- Check for and dispute any errors.
Pay Bills on Time
- Set up payment reminders or automatic payments to avoid late payments.
Reduce Credit Card Balances
- Aim to keep your credit utilisation ratio below 30%.
- Pay down balances each month or consider a balance transfer to a lower-interest card.
Avoid New Credit Applications
- Limit applications to prevent multiple hard inquiries on your report.
- Research lenders’ criteria before applying to increase approval chances.
Increase Your Credit Limit
- Request a higher credit limit to lower your credit utilisation ratio.
- Keep spending in check to maintain low balances.
Keep Old Accounts Open
- Maintain older accounts to benefit from a longer credit history.
- Avoid closing accounts, even if you don’t use them regularly.
Diversify Your Credit Mix
- Include different types of credit, such as credit cards and instalment loans, to boost your score.
- Have a mortgage (this significantly boosted my credit score).
By following these steps, you can steadily improve your credit score, opening the door to better financial opportunities and stability.
Conclusion
Exploring personal finance options is essential for financial stability. Understanding debt and credit is key: debt is borrowed money that must be repaid with interest, while credit is your borrowing capacity.
Good debt, like student loans, mortgages, and business loans, can provide returns on investment. Bad debt, such as payday loans and high-interest credit card debt, can lead to financial distress.
To improve your credit score, review your credit report for errors, pay bills on time, reduce credit card balances, avoid new credit applications, increase your credit limit, keep old accounts open, and diversify your credit mix.
Managing debt wisely and improving your credit score can enhance your financial opportunities and security.
