Lending and Borrowing

What is "credit"?

Credit is when someone (often a bank or a business) agrees to lend you money for a period of time, or lets you buy something and pay for it at a later date.

So, credit is borrowed money.

There will be specific terms and conditions attached to this agreement. They’ll explain how you need to pay the money back.

What is "debt"?

When you borrow money (credit), debt is the money you owe.

In a debt-based financial arrangement, the lender gives the borrower permission to take some money, and pay it back later.

There are usually agreed conditions, including repayment dates, interest rates and late fees if the repayment dates are not met.

There are lots of ways we can get credit and have debt. Here are two of the ways...

Interest rate

When a company or bank lends you money, they will charge you money. If they lend you £100 they will always charge you more than that in total. Otherwise, what’s in it for them?

Interest rate is the amount that is charged for a loan or purchase made on credit. They usually state this as a percentage of the loan. The interest rate represents the cost to you, the borrower, for taking out the loan or making a purchase on credit, and is the rate of return for the lender or creditor.

It’s usually best to pay interest at the lowest rate possible.

APR

APR stands for Annual Percentage Rate.  It is a broader measure of the cost of borrowing money than an interest rate. It reflects the interest rate, any points and other charges that you pay to get the loaned money. For that reason, your APR is usually higher than your interest rate.

This is to help you understand the cost of borrowing the money and help you to compare different offers from other lenders. An APR tells you how much you can expect to pay for every year you use the money, and it includes any fees.

Generally speaking, the lower the APR, the less additional cost you will pay.

Let’s look at an example…

You want to borrow £900 over three years.

• If the APR is 10% you will have to pay back £1,038.91, therefore the loan will cost you £138.91
• If the APR is 20% you will have to pay back £1,177.38, therefore the loan will cost you £277.38
  (although you should always check the terms and conditions).

Credit cards

A credit card is a card that allows you to borrow money from a bank, a building society or lender, to pay for the things you want to buy, now!

If you sign up to get a credit card, you are promising that you will repay the card provider what you owe at a future date. It can sometimes be useful to have money up-front (e.g. if you want to buy something big). With a credit card, you would then pay back that money over a longer period of time and you will probably pay interest on it too (this means that in the end you will pay back a bigger sum than the one you borrowed).

If you pay back all the money you have borrowed each month, you won't get charged interest. If you don’t pay it back then the interest will be added. If you keep on spending money on a credit card, but not paying any of it back, it will start to charge you more and more. You can face high interest rates if you don’t pay back what you owe each month.

Credit card providers will also set a limit on the amount you can borrow and have fixed rules for paying off the debt – normally a minimum amount each month.

Being overdrawn

This is when you take money out of your bank account that you don’t have!

Let’s say you have saved £200 and it is sitting in your bank account. If you then buy something that costs £300, you will be £100 overdrawn.

Sometimes banks will allow this if you have agreed it with them (it's called an overdraft, the amount they will allow you to be overdrawn) but often, they will charge you money if you are overdrawn.

Credit Score

When a bank or other organisation is deciding whether they’ll lend to you, they might check your credit score.

Your credit score, or credit rating, is a three-digit number that tells them what kind of borrower you are, and usually ranges between 300-999. The higher the number, the better your credit score is.

A score above 800 is considered excellent, those above 700 are normally fair or average, while scores between 300-580 are often deemed very poor.

Lenders calculate credit scores in different ways, but essentially your score’s influenced by how much debt you’re in and how good you are at repaying it.

If you manage debt badly, you’ll get a poor credit rating, and that can take a long time to improve. It can affect some pretty important things down the line, from getting a mortgage, buying a car, or even just a mobile phone contract. Your credit score might even be checked by a company before they offer you a job.

That’s why it’s important to try and keep your credit score healthy and high!

The upside of credit and debt

Being able to get credit is really helpful. It gives us more flexibility and options in how we manage our money.

For example:

• Most people wouldn’t be able to buy a house if there wasn’t the option of getting a mortgage.
• A credit card helps us to spread a cost out over time, which can be helpful as we budget and manage our finances.

All of these different options for credit require us to be in debt.
As we saw, “debt” means money that you owe someone else.
If you manage it well and can afford to pay it back, debt’s not a problem.

Be careful

Of course, we have to stay on top of these different forms of credit and make sure we really know what the terms and conditions are, and what they mean for us.

• When we borrow money, we may need to pay interest, extra fees, or charges. So we end up paying more than we borrowed.
• When credit is available, it can be tempting to borrow more money than we really need.

We need to be careful. If not, we can find ourselves in a level of debt we’d struggle to get out of.
A ‘debt spiral’ is when you continue to fall deeper and deeper into debt, even if you’re staying on top of your current payments.
It’s a really worrying situation to be in and can impact on your mental health and wellbeing, as well as your finances.