Learning the basics about debt

Debt isn't inherently good or bad—it's a tool that can work for or against you, depending on how it's used. Understanding how debt works, how lenders operate, and when borrowing can be beneficial or harmful is crucial to managing your finances effectively. Let's break it down.

Banks Need to Lend Money: The Business Model

You may not realise this, but most of a bank’s income comes from interest and fees. Interest is generated from loans created by the bank, so it’s in the bank's interest to lend money. That’s why an 18-year-old may find themselves being offered a personal loan, even before they have a full-time job or built up any credit history

It doesn’t matter how bad your credit file is; there are so many lenders in the market that it is very hard not to find at least one who will agree to lend you money. However, it may cost you substantially more than someone with a high credit score. You are perceived as a risk if you have a poor credit rating. The lender will want to make the risk worthwhile and will be aware that your options are few.

Understanding the above is an important starting point. Knowing this will help you understand that banks and lenders are businesses, just like any other business، for example, Amazon.

In the same way that Amazon will always send you offers to encourage you to buy, banks and other lenders will send you offers to encourage you to borrow. You are a customer to them; they want your continuous business. Amazon may send you an email suggesting an item like a Dyson vacuum cleaner. You didn’t search for a Dyson on Amazon and never felt you needed one. However, you will still receive the email to entice you to buy. Banks and lenders work the same way; you didn’t ask for a loan or a credit card, and you didn’t search for them either. However, the banks and other lenders may send you an email or letter to entice you.

New business is essential for any business. Most people in the UK have some borrowing, usually with the bank that receives their income. A bank account is needed in the UK to receive income, so as you must be 16 years or older to have a bank account, banks will provide attractive offers to 16-year-olds to open accounts with them.

If the account holder is eligible to borrow at 18, there’s a high chance they will borrow from the same bank that receives their income.

Like any other business, a bank or lender strives for repeat business. You can pay off a personal loan, but don’t be surprised if an offer for another one arrives shortly after.

Lending money is competitive, so banks and lenders must ensure you don’t take your business elsewhere. If you've borrowed before, they tend to believe you will borrow again. If you default on a debt, the default will sit on your credit file for six years.

Negative marks will affect your ability to borrow—well... they’re supposed to. However, many people have received offers to borrow money or take out a credit card while marks like CCJs are still on their credit file. Banks and lenders are in the business of lending; they still need to make money, even when it’s a risk.

When you walk into a fast-food restaurant like McDonalds, you probably know what you want. It could be a Big Mac meal; this is what you fancy. The person taking your order will likely ask you if you want to supersize the meal or if you want to add an apple pie to the order. The person taking your order is trained to maximise the income from your visit.

In the same way, don’t be surprised if you have a credit card with a bank and you are spending heavily on it, only to be offered a higher credit limit. The more you spend, the more interest the bank can generate, specifically if you only make minimum payments. Banks can maximise their income by giving you more to spend, i.e., a higher credit limit. If you cannot manage a higher credit limit, you should never accept one. You can refuse it. If a bank automatically increases your credit limit, you can ask for the increase to be removed.

Debt becomes a problem when borrowing to subsidise your general day-to-day spending. This shows that you are living outside of your means. It is not sustainable in the long term. The sooner you address this, the better; nip it in the bud before it spirals out of control. Our budget planner is a tool that everyone should be using regularly to stay within their means. If you do not know what you are spending and use credit to keep you afloat each month, you are at high risk of financial difficulty.

When borrowing can lead to profit, debt can be a valuable asset. Understanding the concept of leverage is crucial. For instance, if you take out a mortgage and later sell the property and make a profit after repaying the mortgage, interest, and any applicable fees, you’ve effectively used bank funds to increase your wealth. We recommend using debt for projects or investments that yield a profit. While this may not always be straightforward, maintaining a mindset of 'How will borrowing this money benefit me financially?' is key to ensuring debt remains a tool for wealth creation, not a burden.

Understanding a subject that plays a crucial role in our lives is essential. This will kickstart your learning in this area. Never participate in a game without understanding the rules. Now that you’re done here, head to another article in our Financial Education section by clicking here to continue gaining knowledge that can help you and others.