Money Lesson 2:
Manage Debt
In today’s financial world, debt has become a common part of life for many individuals and households. Whether it’s funding education, buying a home, or covering unexpected expenses, borrowing is often necessary to achieve various goals. But it’s important to make sure debt is managed effectively to avoid financial strain. In this lesson, we’ll explore what debt is, the difference between “good” and “bad” debt, and effective strategies for managing debt to ensure it doesn’t derail your financial health.
What is Debt?
Debt is something, usually money, owed by one party to another. You might borrow money to buy things like a house, a car, or pay for school fees. But you have to pay back the money you borrowed, usually with extra money called interest. If you don't pay back what you owe, you might have to pay even more, face repossession, or other consequences such as a bad credit score.
Many people encounter debt in their everyday lives, sometimes without even recognising it as such. Overdrafts, credit cards, mortgages, and Buy Now Pay Later arrangements like Klarna are all examples of debt products commonly used to manage finances and make purchases.
Debt can be an extremely useful tool if used sensibly. For example, it is commonly used by individuals to fund large purchases such as a house, which we don’t always have enough money to fund outright at the start.
However, debt can also be very risky if you’re not careful. Sometimes people borrow more than they can afford to pay back, or their situation changes—like losing a job—so they suddenly can’t keep up with the repayments. When this happens, interest builds up fast, and it can become hard to even pay the interest, let alone the original amount you borrowed. Your credit score can also take a hit, making it harder to borrow money in the future. This can lead to a downward spiral that’s tough to escape from. That’s why it’s so important to understand how debt works and think carefully before taking it on. Making smart decisions about debt will help you stay in control of your finances.
Common Types of Debt
There are lots of different types of debt there, so here is a quick overview of some common types:
Credit Card Debt
This is one of the most common types of debt, and it’s easy to accumulate quickly. If you don’t pay off your credit card balance in full each month, you’ll be charged high-interest rates, often 20% or more, which can make it difficult to get out of debt.
Buy Now, Pay Later / Catalogue Debt
This type of debt allows you to purchase items and pay for them over time. However, it’s important to remember that if you miss payments, interest rates can skyrocket.
Overdrafts
An overdraft allows you to spend more money than you have in your bank account, but it comes with fees and interest, which can make it an expensive short-term solution.
Student Loans
These loans are used to pay for education and typically come with lower interest rates. In some cases, the remaining debt may be forgiven after a certain period.
Payday Loans
These short-term loans are designed to cover immediate expenses but come with extremely high-interest rates, often creating a cycle of debt if not repaid quickly.
Mortgages
A mortgage is a long-term loan used to purchase real estate. It’s typically considered “good debt” because it allows you to invest in property, which may increase in value over time.
Car Finance
Loans or finance agreements, like Hire Purchase (HP) or Personal Contract Purchase (PCP), are used to buy vehicles. Be mindful of interest rates and monthly payments, as they can add up.
Tips on managing debt effectively:
Stick to ‘good debt’ rather than ‘bad debt’
Understanding the difference between good debt and bad debt is crucial for making sound financial decisions.
Good debt helps increase your wealth or future income, such as a mortgage for buying a home or student loans for education. These investments offer potential long-term benefits.
Bad debt often involves borrowing for non-essential items that don't increase in value, like credit card debt from shopping sprees or vacations. These debts can lead to financial trouble because they don't provide lasting value.
Here are some more examples of what counts as ‘good debt’ vs ‘bad debt’:
Good Debt
- Mortgage for purchasing a home
- Student loans for education
- Business loans for expanding a business
- Car loans for reliable transportation
Bad Debt
- Credit card debt from unnecessary shopping
- Payday loans with extremely high-interest rates
- Loans for luxury items or vacations
- High-interest personal loans for non-essential expenses
- Borrowing to cover daily living expenses without a plan for repayment
It’s perfectly normal to have some debt, and it can even be a helpful tool. The key is to stick to ‘good debt’ whenever you can. With good planning and budgeting, you can avoid needing ‘bad debt.’ For example, people often use bad debt to pay for big, unexpected expenses, but this can usually be avoided if you save up in advance as we’ll cover in the next money lesson.
Some people use ‘bad debt,’ like credit cards, not to buy things they can’t afford, but to earn rewards such as cashback or points. This can be fine—as long as you use it responsibly. Follow these tips to stay on track:
Always pay off your balance in full every month to avoid interest charges.
Never miss a payment—set up a direct debit to make sure you never forget.
Don’t go over your credit limit or max out your card, as this can hurt your credit score.
Keep your spending below 50% of your credit limit if you can—using too much of your limit can also impact your credit rating.
Check your statements regularly for any errors or fraud.
Use it only for planned purchases—avoid using them to cover expenses you can’t afford.
If you follow these tips and keep your borrowing under control, you can enjoy credit card rewards without running into financial trouble.
Always Have a Plan to Pay it Off
Before taking on any kind of debt, make sure you have a clear plan to repay it — and aim to pay it off as quickly as possible. One of the biggest pitfalls is only making the minimum payment each month. While this might seem manageable, it’s often a trap that leads to mounting interest charges and long-term debt.
Let’s look at an example using the interactive calculator below:
Imagine you have £5,000 of credit card debt with an interest rate of 40% APR. If you only pay the minimum each month — say £100 (about 2% of the balance) — your repayments barely cover the interest. The debt lingers for years, and you may never actually repay the full amount.
Now increase your repayment to £250 per month. You’ll clear the debt in about 2.8 years, with a total cost of £8,377. Still costly — but far better than letting interest pile up.
The takeaway - always aim to repay the full balance each month, or as much as you can afford — not just the minimum. The faster you pay off debt, the less interest you’ll pay, and the more control you'll have over your finances. It's one of the smartest ways to avoid high costs and escape the risk of a debt spiral.
Take out the Minimum Amount
Assess your needs realistically and borrow only what is necessary. Avoid the temptation to borrow more than you need, as it can lead to unnecessary financial strain.
Debt is often given out very easily and people often stretch themselves at take out the maximum amount possible. However, this can be a bad idea because if your financial position unexpectedly changes in future (for example you have to take some unexpected unpaid leave from work) you may be left struggling to repay the debt.
So don’t overstretch yourself and take out the minimum amount of debt wherever possible. You should be able to comfortably pay all of the repayments on your debt, preferably with some wiggle room to cover any changes in your financial situation or higher interest rates. If you can’t do this, you should look to reduce the amount of debt you have, which we cover in more detail later on.
Watch out for High Interest Debt
Before you borrow money, always check the interest rate. The higher the rate, the more you’ll pay back in total. For example, if you borrow £1,000 at a 5% interest rate for one year, you’ll pay back £1,050. If the rate is higher, the cost goes up quickly.
Look for the lowest interest rate you can find whenever you need to borrow.
In the UK, interest rates are influenced by the Bank of England, but your personal rate will depend on the lender and your credit history. Lenders set their own rates based on how risky they think lending to you is, and they add their profit margin on top.
When you shop around, check the APR (Annual Percentage Rate). This figure includes not just the interest, but also any fees—so it gives you a fair way to compare different loans or credit cards.
Remember: interest compounds. This means you might end up paying interest on top of previous interest charges, not just on the amount you first borrowed. Over time, this can make your debt grow much faster than you’d expect.
Bottom line: High-interest debt is expensive and can build up quickly. Always compare rates, understand all the costs, and aim to pay off high-interest borrowing as soon as you can.
Monitor Your Credit Score
Your credit score wields significant influence over your ability to navigate debt effectively due to several key factors:
Access to Credit: A robust credit score enhances your prospects of securing loans and credit cards with favourable terms, facilitating smoother debt management.
Lower Interest Rates: Higher credit scores often translate to lower interest rates from lenders, resulting in reduced overall borrowing expenses.
Given these pivotal roles, vigilance over your credit score is paramount. Ensuring its accuracy is crucial as errors could detrimentally affect your financial standing. Moreover, proactive steps to bolster your score are imperative for long-term financial health.
If uncertain about your current credit rating, fret not; you can obtain this information free of charge through online platforms. The three major credit agencies—Equifax, Experian, and TransUnion—maintain credit reports on individuals. Regularly monitoring all three reports is advisable, as each holds sway over your financial profile. You can check the reports online for free using the following links:
Check Your Credit Score
Want to understand where you stand financially? Check your credit score with one of the UK’s major credit reference agencies below:
How to clear existing ‘bad debts’
If you already have a number of debts that you are trying to clear then a structured approach can make a significant difference. Here are some key steps that we would recommend following to guide you on the right path:
Identify and Prioritise Debts
Categorise your debts into priority and non-priority categories. Priority debts, such as mortgage payments and utility bills, should take precedence due to the severe consequences of non-payment. If you don’t pay these you could lose your home or your utility services could be cut off.
Create a Repayment Plan
Once you've prioritised your debts, develop a repayment plan that allocates funds towards paying off each debt systematically. Consider focusing on debts with the highest interest rates first to minimise overall interest costs.
Once you have made your payments to your priority debts, you should then start to look at your non-priority ones. The order in which you then decide to pay these is down to you, but it’s worth addressing the ones that carry the highest interest rate first, so that the total amount you owe does not spiral upwards.
Budget Wisely
Take control of your finances by creating a budget that accounts for both essential expenses and debt repayments. Adjust your spending habits to free up extra funds for debt repayment, if necessary.
Explore Debt Consolidation
Consolidating high-interest debts into a single, lower-interest loan can simplify repayment and reduce overall interest costs. However, carefully evaluate the terms and conditions of consolidation options before proceeding.
Seek Professional Assistance if Needed
If you're struggling to manage your debts independently, don't hesitate to seek help from financial advisors or credit counselling services. They can provide guidance and support in developing a sustainable debt management plan.
Congratulations — you’ve just tackled one of the most important areas of personal finance: understanding and managing debt. By learning how to spot risky borrowing, avoid the debt spiral, and pay off balances in full, you’re putting yourself back in control.
Now that you’ve got a handle on debt, it’s time to look forward. In our next lesson, we’ll show you how to start building savings — even if it’s just a little at a time. Because saving regularly is one of the simplest and most powerful ways to build financial confidence.