Debt 101

Course: You and your money

Assets vs Liabilities

In personal finance, an asset is something you own that has value—such as money in the bank, property, a car, or stocks. These are things that contribute to your financial strength because you can sell them or use them to earn income. On the other hand, a liability is money you owe, like a mortgage, credit card balance, or student loan. Liabilities weaken your financial position because they must be paid back.

To understand your financial health, you subtract your total liabilities from your total assets. The result is your net worth. For example, if you own a house worth £200,000 but owe £150,000 on it, and you also have £10,000 in savings and £5,000 in credit card debt, your net worth is £55,000.

$$NW = (£200,000 + £10,000) - (£150,000 + £5,000) = £55,000$$

Understanding Debt

Debt is the total amount of money you owe at a given time. Taking on debt—also called borrowing—can happen through loans, overdrafts, or using a credit card. There are two main types of debt: secured and unsecured. Secured debt is tied to something valuable you own, like a house. If you can’t repay the loan, the lender can take that asset. Mortgages are a common example. Unsecured debt, like credit cards, isn’t tied to a specific item, so the lender takes more risk and usually charges higher interest.

If you miss a loan payment, it becomes an arrear, meaning it’s overdue. Missed payments can lead to penalties and harm your credit standing.

Property Equity

If you own a home, your equity is the part of the property’s value that’s truly yours—what’s left after subtracting your mortgage balance. For instance, if your house is worth £250,000 and you still owe £180,000, your equity is £70,000. Some people use equity withdrawal to borrow against this value, often to fund renovations or repay other debts.

Financial Institutions

When it comes to financial providers, banks are profit-driven companies owned by shareholders. Building societies, however, are owned by their customers and often focus more on serving members than generating profits.

Components

When you borrow money, what you pay back includes the principal (the original amount borrowed), interest (the cost of borrowing), and sometimes additional fees, like arrangement or early repayment charges. Loans can be interest-only, where you pay back just the interest during the term and the full amount later, or repayment loans, where you pay down both the interest and the loan itself over time.

Interest Rate

Bank Rate

In the UK, the Bank of England sets the country’s official interest rate, known as the Bank Rate. This is done by a group called the Monetary Policy Committee (MPC), which meets monthly to review the economy and target inflation—ideally keeping it around 2%. If inflation is getting too high, the Bank may raise interest rates to slow spending. If the economy needs a boost, it might lower them to encourage borrowing.

The Bank Rate influences how much lenders charge on loans and mortgages. If it goes up, borrowing usually becomes more expensive; if it falls, loans often get cheaper.

Nominal vs Real

The nominal interest rate is the rate you see advertised—say, 5% per year. However, it doesn’t account for inflation, which affects your money’s purchasing power. Once you subtract inflation from the nominal rate, you get the real interest rate. For example, if the nominal rate is 0.5% and inflation is 4.7%, the real interest rate is –4.2%. That means your savings are losing value in real terms, which might encourage people to reduce debt instead of saving.

Interest on Loans

If you borrow money but make no repayments during the year, you’ll pay interest on the full amount. For instance, a £10,000 loan at 7% will cost £700 a year. However, if you start paying down the loan, interest is usually calculated on the average balance during the year, which reduces the cost. For example, if you start with £10,000 and end the year at £8,800, the average balance is £9,400. At 7%, you’d pay £658 in interest—less than the £700 if no repayments were made.

Interest can be calculated daily, monthly, or annually—daily calculations are typically cheaper if you repay regularly.

Interest = Principal × Interest Rate

There’s also compounding, where unpaid interest is added to the loan, so future interest is charged on a higher amount (interest on interest!). Over time, this can significantly increase your debt. For example, a £1,000 loan at 35% left unpaid for 10 years could grow to over £20,000.

Types

The interest rate on a loan can be set in different ways. A variable rate changes over time, often following the Bank of England’s rate. Some loans, called trackers, are directly linked to it. A fixed rate stays the same for a set period, providing predictability. A capped rate can go up or down with the market but has a maximum limit, while a collared rate stays within both a maximum and minimum.

Most personal loans have fixed rates, while credit cards and overdrafts usually have variable ones. Mortgages may use any of the three structures.

APR

Because interest charges can include more than just the percentage rate, the UK uses the Annual Percentage Rate (APR) to help you compare loans more fairly. APR includes the interest rate plus any required fees and considers the timing of those payments. However, it excludes optional extras, like optional insurance or penalties that only apply in special situations. A lower APR generally means a cheaper loan.

The Base Rate is just the starting interest rate set by the Bank of England. It doesn't include fees or loan-specific conditions. So, while the base rate affects what lenders charge, the APR tells you what you’ll really pay.

Household Debt

Debt and spending are tightly linked. When you take on debt, you’re committing to future expenses—repaying the principal and paying interest. At the same time, if your household spends more than it earns and doesn’t have savings, it may turn to credit cards or overdrafts, creating new debt.

Paying off debt reduces your overall liabilities, but only if your payments cover more than just interest. For example, if you borrow £10,000 to buy a car, that’s a liability. Your monthly payments to repay it become part of your regular expenses.

Credit Score

Savings products and debt products are provided by the same institutions – such as banks and building societies – and these institutions make their profits from the difference between them.

Your credit score affects whether you can get a loan and at what rate. Even high earners can be rejected if their credit history is poor. Lenders usually assess your creditworthiness by looking at four things:

First, they check if you’ve defaulted on loans in the past. If you’ve had a County Court Judgment (CCJ) or similar, your application may be rejected automatically. Then they test affordability—do you have enough income left after your regular expenses to take on new debt? They also look at personal stability, such as how long you’ve lived at your current address or used the same bank account. Frequent changes may raise concerns. Finally, security matters—offering an asset (like a house or car) as collateral can lower your risk and help you get better loan terms.

The result isn’t always a clear yes or no. Your credit score also affects how much you can borrow and what interest rate the lender will offer.