Debt, something that almost everyone knows about or has been into, has become an integral part of our lives. It is not just individuals who have been increasingly relying on debt, but also corporations and large institutions depend on debt to manage their finances. In this article, we are going to talk about what debt is, how to manage it well, and what happens if you do not keep a close eye on your debt and it spirals out of control.

What Is Debt?

Debt is something that is owed to someone else, typically money. It could be between individuals, between corporations, and even between countries. Friends and families usually lend each other money for varying needs. For example, your friend needs some money to pay his tuition fee for the semester, or you lend money to your brother to help him buy a cell phone. This usually comes with a promise to pay it back in a defined period. Helping each other out in times of need is not uncommon.

Similarly, another example would be someone who just graduated from college and is looking to buy a car for his/her daily commute to work or for leisure. The person would then typically approach a bank to apply for a car loan, which would be given to him after establishing his income and his ability to repay the debt. Another common debt that people take is a home loan, as a house is an expensive asset. The individual approaches the bank, and a similar process of adjudication and determination of repayment ability is determined before the loan is granted. So, taking debt in itself is not bad as long as one has the ability to repay it on time.

Budgeting: The Key to Financial Health

What is budgeting? Budgeting is simply a plan showing how you would be managing your expenses. Why is budgeting important? Budgeting is important to ensure you do not spend more than required or spend unnecessarily. A person or an organization establishes a budget to ensure that the expenses do not exceed the income. For example, a person makes a budget that defines how much he/she would spend on groceries every month, how much would be allocated to entertainment, rent, insurance, etc.

It is important as it defines the choices you need to make—which product to buy and which one to avoid. Budgeting allows you to follow a disciplined and strategic way to manage your income and expenses so that you do not get into debt that you could have avoided. Sometimes it means holding back on luxury purchases or vacation trips. It is not that one should forego these altogether; rather, it’s all about managing them well based on the current financial situation, as people’s financial situations change over time. Maybe what you can buy right now cannot be bought later, or what you cannot buy right now due to financial constraints could easily be bought a few weeks or months later.

People switch jobs, gain new skills, progress in their careers, and expand their businesses, all of which enhance their financial health. And people also lose jobs, lose money in business, or become victims of fraud or theft, which worsens their financial health. So, budgeting your expenses and needs is critical to ensure good financial health and well-being.

Understanding Credit Scores

A credit score is a great tool that shows how good one is at managing their debt. The score ranges from 0 to 900, with a higher score showing efficient management of debt. The factors that affect a credit score are as follows:

1. Payment History

This highlights how you have made your payments. Have you paid the installments on time and in full, or have you been late in any of those? For example, have you been paying your credit bills on time by the due date in full, or are you just making the minimum payment? Have you ever paid the bill late? All this affects the payment history.

2. Amounts Owed

This shows how much you owe to the creditors. For example, a house loan could be for $500,000, while a credit card bill could be $2,000.

3. Length of Credit History

This signifies how old your credit history or your credit file is. How long have you had debt for? A long credit history of over 5 years with timely repayments on loans has a positive impact on the credit score compared to a newly opened one.

4. Credit Mix

This shows the diverse types of credit that you have. For example, a credit card is a type of credit known as revolving credit. You are assigned a credit limit by the bank, you use a portion of it for your purchases, pay the bank back in full by the due date, and you get your full credit limit back again. Hence the name revolving credit. Another example of a revolving credit product is a line of credit.

5. Credit Utilization

This refers to the percentage of utilization of the credit granted. For example, Person A has a credit card limit of $10,000, of which he utilizes only $3,000. The credit utilization percentage for him is $3,000/$10,000 * 100, which is 30%. Another person, Person B, has the same credit limit of $10,000 but utilizes $7,000 from it. The credit utilization percentage for him is $7,000/$10,000 * 100, which is 70%. The lower the credit utilization percentage, the better it reflects on the credit report.

Analyzing the credit report is an integral part of the credit adjudication process, alongside other factors like income determination, account activity, etc.

Types of Loans: Term Loans vs. Revolving Loans

1. Term Loans

A loan that is repaid in payments over a defined period. Terms for the loans can range from 1 year to 7 years usually but can also go up to 30 years for home loans. There are two components of the installment payment, which are the principal and the interest. An example here would be a car loan. The car is bought by paying the full amount to the seller, but the buyer would be paying an installment payment over a period referred to as the term until it is fully paid down. These types of loans are typically given for large asset purchases like a car, house, etc.

2. Revolving Loans

Revolving loans, as the name suggests, are loans that are utilized and paid off in a brief period, like credit card debt. Purchases are done on a credit card, and the outstanding amount is paid off before the due date, which is usually around 40 days from the purchase date, although it may vary a bit depending on the credit card issuer.

For example, you have a credit card with a credit limit of $10,000. You use it to make purchases for your monthly expenses, which include groceries, entertainment, transport, etc., amounting to $5,000. You then pay it off within the stipulated time of 40 days, and you are now ready to use the card again for next month’s purchases.

There are diverse types of credit cards available in the market, offering varying benefits like cashback, travel benefits including travel insurance, movie points earned on purchases made through the credit card, access to lounges at various airports across the world, etc. The decision to choose the right credit card can be a tricky one, as it varies from one individual to another.

A person who travels a lot would benefit from a travel-oriented card offering benefits like lounge access at airports worldwide or travel points earned through purchases on the card, helping them to upgrade to a higher ticket category or even to purchase a free ticket if they have accumulated enough points for it. Meanwhile, a person who uses the credit card mostly for grocery and entertainment purposes would benefit more from a cashback card, which gives you some cashback on each purchase, usually ranging from 1% to 3%. So, choosing the right credit card wisely is important if you want to gain the best rewards from it.

What’s Next? Debt Consolidation and Paying Off Debt Faster

In the next article, we will talk more about debt consolidation, paying off debt faster, the difference between high and low-interest debt, and what happens when you don’t pay off your debt on time.