Lesson 3: Credit, Debt, and the Cost of Borrowing

Interest & Credit

Credit is one of those financial instruments that shape not just what people buy but when they buy it and for how long they pay it off‚ all the way down to whether they can buy it on credit․ Credit is simply borrowing money․ Your credit is your ability to borrow now and pay back later, generally with additional interest as well (CFPB, 2023; Bank of England, 2022).

That 'extra' is called interest‚ and it's what makes debt powerful or dangerous․ Interest is simply the price of borrowing money․ So‚ if you borrow £100 at 10% interest‚ at the end of a year you owe the lender £110‚ not just £100․ 

In most cases‚ debts do not stop there․ If the debt is not paid promptly then interest will be compounded‚ and another layer of interest will be added on top of the debt․ That is what makes debt grow quietly in the background over time․

Borrowing

This is also why borrowing is so easy‚ and then feels so difficult: a credit card feels like a safety net‚ a way to spend now and worry later․ When only minimum payments are made‚ the debt can last for years and potentially cost several times the original purchase (Agarwal et al., 2010)․

Debts

Nevertheless‚ not all debt is created equal․ Economists often talk about "good debt" as opposed to "bad debt"‚ but there is nothing moral about the distinction between those two․ Good debt is money that you borrow to invest in your long-term opportunities or earning potential․ Good debt includes student loans that you may take out to pay for your education and increase your earning potential․ A mortgage is also considered good debt because the value in real property may increase and provide stable housing for the borrower (OECD, 2021; Dynan & Kohn, 2007).

Bad debt‚ on the other hand‚ usually refers to debt incurred to acquire things which lose value or yield no future income‚ such as consumer debt used to purchase rapidly depreciating products such as clothing‚ luxury goods‚ or holidays on hire purchase․ It's not that these things are "wrong"‚ it's just that they may limit your future financial potential while producing little in return (Mankiw, 2021; Lusardi & Tufano, 2015)․

Psychology & Borrowing

But there's a psychology to borrowing that maths can't explain․ Credit cards and "Buy Now‚ Pay Later" schemes have been designed to feel different to spending․ You don't feel as though you're spending money because it's just not leaving your hands‚ and you don't feel like you owe anything․ This creates‚ psychologists say‚ a "present bias‚" a tendency to favor immediate rewards over future payoffs (Lusardi & Tufano, 2015).

And this is why even people who know better can get into trouble with debt․ It's not just numbers‚ it's about behavior․ Little decisions‚ made habitually (I will pay that later‚ or it is only £20 a month)‚ create a long-term habit․

Credit is not intrinsically bad‚ the key is understanding the important role it plays in people's lives‚ how it can be used appropriately to open doors‚ and how it can be used irresponsibly to limit freedom in the future․

The secret of debt is that every time you borrow‚ you're not just moving money through time‚ you're moving risk through time․

References:

Agarwal, S., Driscoll, J. C., Gabaix, X., & Laibson, D. (2010). The age of reason: Financial decisions over the life cycle. Quarterly Journal of Economics.

Bank of England (2022). Money and credit: definitions and overview.

CFPB (Consumer Financial Protection Bureau) (2023). What is credit?

Dynan, K. & Kohn, D. (2007). The rise in U.S. household indebtedness. Brookings Papers on Economic Activity.

Laibson, D. (1997). Golden eggs and hyperbolic discounting. Quarterly Journal of Economics.

Lusardi, A. & Tufano, P. (2015). Debt literacy, financial experiences, and overindebtedness. Journal of Pension Economics and Finance.

Mankiw, N. G. (2021). Principles of Economics. Cengage Learning.

OECD (2021). Household debt and financial vulnerability.

Prelec, D. & Loewenstein, G. (1998). The red and the black: Mental accounting of savings and debt. Marketing Science.