All of us have borrowed something or the other at some point in our life. Whether it is something as small as borrowing a pen or pencil in school or something big like borrowing a loan from a bank, every time you borrow something you are considered to be under a debt until you return whatever you have borrowed. So whether it is in the form of borrowed money from a friend or loan from a bank, we have all encountered debt at some point in our life. Although not all debts are bad and with so many offers on credit and debit cards it is often tempting to go for debt when in a difficult financial situation, there have been many studies showing that debt is one of the main reasons why most people end up in financial trouble.
However, if you make proper planning before going for a loan then it actually may turn out to be a good option to get help in a financially critical situation. This is why understanding what debt is and when it is beneficial to go for debt is absolutely necessary before choosing to borrow a loan and go into debt. In an effort to understand debt better, let’s go through the basics of the concept of debt and how it may be useful for you in solving long term financial problems.
What is Debt?
The term debt refers to the amount of money that one person owes to another person. The most common and popular types of debt are loans that are with or without mortgage and credit card debts. Debt is lended from one person to another at a fixed or floating rate of interest. The concept of debt gives the borrower the permission to borrow a fixed amount of money under the condition that the money is paid back at a certain date which is pre decided.
This return usually comes with interest. In its literal meaning, the word debt has been derived from the French word “dette” which means obligation. In simple words, you can say that debt is the money brought from someone for something that you cannot normally afford. Usually large expenses like education fees, buying a new house or a new car are handled by borrowing a loan and choosing to go into debt.
Home loans, car loans, mortgage loans, credit card debts and income taxes are the most common and popular types of debts that are owed by households and individuals. An individual usually chooses to go into debt in order to use an anticipated income combined with the future purchasing power at present before earning the same. However, when it comes to large corporations, there are many options available when it comes to debt. Such large corporations usually opt for debt for their day to day business operations or their working capital. This debt can be either long term or short term. Companies also have an option of adding debt to their capital structure in the form of term loans or bonds. Some other financial options include a letter of credit and guarantee.
All the banks under the regulation of the Reserve Bank of India or RBI play an important role in lending loans to the ones in need by acquiring the necessary documents according to the guidelines set by the RBI.
Types of Debt
Now that we have gone through the basic concepts of debt, let’s see the different types of debts and how they work. Debt is widely classified into four types—secured debt, unsecured debt, good debt and bad debt. We will have a look at each of these types individually to understand them a little better.
Secured debt The debt that is backed by an asset or any form of guarantee that can be used as a collateral for the debt is called a secured debt. Before lending the debt, the lender usually checks the borrower’s credit history in order to make sure that the borrower is going to be able to return the debt in the given time. This act makes the debt secure. For example, when you buy a house by lending a loan and fail to repay that loan in the specified time, the lender who usually is a bank will take possession of the house. Such secure loans usually come with low interest rates.
Unsecured debt As opposed to secured debts, unsecured debts are those that are taken without any collateral. Such debts put the lender in an unsecure position with no guarantee from the borrower that the debt will be returned on time or for that matter returned at all. The lender can however take legal action if the borrower fails or refuses to return the debt. As unsecured debts come with a higher risk, the interest rates on these debts are also high.
Good debt Whenever you are opting to go for a debt, one of the most important things to consider is whether the debt is good or bad. A debt that generates long term income and grows in value is considered to be a good debt.
Bad debt A debt used for things that lose their value fast can be considered as a bad debt. Such debts do not generate long-term income and carry high interest rates. A credit card debt can be considered as an example of a bad debt and the one way to decide if you should take such a debt is to consider if you can really afford to pay it off.
What are the benefits or advantages of Debt?
Although debt can be sometimes overbearing and cause stress if you are not able to pay it off on time, it also comes with its own set of benefits and advantages. The benefits of taking a debt are as follows:
- If you avoid bad debt, there are a lot of benefits you can reap from a good debt. One of them is to have a source of free income which adds to your regular income so that you can use it to solve your financial troubles.
- Once you have some extra money you get more freedom to go for investment options to keep that money safe while also growing your finances for a complete financial security.
- Debt also gives you an active credit score.
- The cost of debt is usually lower than an equity and it also comes with a lower risk than an equity.