What you really need to know before you use credit

What is debt, exactly?

Whether you are popping something on a credit card, signing up for Buy Now, Pay Later, or taking out a personal loan, a car loan or a mortgage – you are going into debt. Whenever you use credit, you are going into debt. It’s just borrowing.

When you borrow, you’re essentially spending other people’s money. It’s a bit like using your future money early – money you haven’t earned yet. That typically comes at a cost, with interest and fees attached.

And of course it will need to be repaid. (Loans that don’t have to be repaid are either gifts… or scams!)

Going into debt is risky business, for both the lender and the borrower. The lender may not be sure if they’ll be paid back. If they think you’re more of a risk, they charge you higher interest. There’s more on how that works below.

As a borrower, your risk is that the loan may seem like a good deal to you, but your circumstances could change, leaving you unable to repay. Or a critical emergency might crop up, so you have to pay for that instead of repaying your loan.

You can be a smart borrower by knowing what you’re signing up for, reading the fine print of your credit contract, and having an emergency fund at the ready if anything goes pear shaped. You’ll want to make sure you have a good plan in place to pay back the money you’re borrowing.

How interest works when you borrow

When you take out a loan or use credit, the price you pay for using other people’s money over time is charged in fees and interest.

Fees

There can be all sorts of fees when you borrow: setup fees, annual fees, late fees, default fees (a penalty if you miss payments).

• While Buy Now, Pay Later companies like Afterpay or Zip don’t charge you interest, they have late fees if you miss your instalments. (They mostly earn their money by charging retailers.)

Your credit contract sets out the fees involved in your loan (it’s typically in the fine print).

Interest

Interest is what you pay for borrowing – the cost of money over time. It’s typically represented as an annualised percentage rate (you’ll see it called an ‘APR’ in the fine print). It’s how much you’d pay over a given year for each $100 borrowed.

Because interest is shown in percentages, these can seem like minuscule numbers not worth paying attention to, but those tiny figures can cost you thousands, even tens of thousands of dollars. Here are some typical interest rates:

• Payday loans: 49.99%
• Store cards: 25.99%
• Credit cards: 19.95%
• Personal loans (including debt consolidation): 12.90%
• Car loans: 13.95%
• Mortgages: 7.34%

You can easily see which type of loan is most expensive from those rates, but how much you end up being charged depends on how long you take to repay. The longer your debt goes on for, the more it costs you. If you take on high-interest debt like a payday loan, it’s best to treat it as an emergency and get rid of it as quickly as possible!

When you borrow, you’ll find your interest rate for your particular loan on your credit contract, but you may not know if it’s a good one or not. One way to compare is at interest.co.nz, which publishes rates for credit cards, personal loans and mortgages. Rates change frequently, and comparing helps you shop around.

When can debt be a good idea?

It feels easy to pay for a meal in a restaurant on a credit card in the moment. But if you take a few months to pay off the credit card, the interest charged makes that meal more expensive every day the debt isn’t paid off. Probably better to save for it and avoid borrowing.

That said, debt can be a good idea in certain cases. Borrowing for assets that can increase in value – such as an education, a property or a business – can help you grow your finances over time.

But some assets lose value after we’ve paid for them, like a common car. Every year the car is worth less. Borrowing to buy a car can be a risky move, especially if it loses value faster than you can pay off the debt. So the more of the car price you can save up ahead of time, the better.

Questions to ask yourself before you borrow money

Whenever you borrow, the key is to have a plan to get out of the debt before you jump in. The risk is that you won’t be able to repay, that you’ll pay too much, or that too much of your everyday money will be going towards repayments. Have a think about:

• How much do I really need to borrow?
• How much interest and other charges will I pay?
• What is my total cost going to be?
• How much will my repayments be?
• How long will I be paying back the debt?
• How often will I make repayments?
• How sure am I that I want to take on this debt?

For more on what to expect from a lender, see this helpful guide from the Commerce Commission. 

How soon can you be debt free?

Staying in debt is not sustainable. Because it costs you in fees and interest, the longer it goes on, the more expensive it gets. It holds you back from getting ahead.

You want to find the quickest way out… and then stay out.