Debt management

Learn more about managing credit to enjoy greater peace of mind and focus in your life. Here we share some tips on credit and what you can do to get started today with your knowledge. 

When you borrow money from another person or institution (such as a bank or credit union), the lender expects to be repaid.  Usually, the person who lends the money charges interest—a fee for the use of that money.  One can be in debt to family members, friends, informal lenders or financial institutions.

What is credit?

Credit is what you owe when you borrow something—cash or tangible goods—from someone else, or when you purchase on credit.  Then you are in Debt.

Commonly, a loan refers to a sum of money that a lender gives to a borrower for a certain period. The borrower commits to repay the money with interest.

The ability to borrow or the sum available for borrowing is referred to as Credit.

Banks and other financial institutions will approve credit to customers who have a good record of repaying their loans on time

Components of Credit

If you borrow money from a bank or other formal lender, you will hear the following terms associated with your loan. It will be important to understand what each means for your specific loan.

• Loan size. The amount you borrow.
• Loan term. The period you have to use the loan money and repay it.
• Interest rate. Percentage of the total loan amount charged to the borrower for the use of money borrowed.  Interest is usually charged every month.
• Administrative charges in addition to interests which are usually paid once, at the time the borrower takes the loan.
• Grace period. The period after receiving a loan and before the first payment is due.
• Repayment schedule. The frequency of loan payments (e.g., weekly, biweekly, monthly)

Why Borrow?

We need to borrow money for many reasons.  Mostly, we borrow to:

• Invest;
• Respond to an emergency; or
• Consume (purchase an item for which we do not have enough money at the time of purchase).

A loan provides you with a lump sum of money that might be difficult to obtain otherwise. It enables you to take advantage of business opportunities, respond to emergencies, make home repairs or purchase something you need. But borrowing money can be expensive and carries obligations to repay on time.  

For these reasons, taking a loan is not the same as using your own money that you may have through wages, business profits or savings. The chart below outlines the advantages and disadvantages of taking a loan.

	Taking a Loan	Using Your Own Money
Advantages	You gain access to more money than you have in savings.You get money quickly when you need it for emergencies.	You avoid the costs of borrowing.You are free to use your money as you wish.You face less risk when you finance your business growth in smaller increments based on what you can afford to invest.You avoid the obligation of future loan repayments.
Disadvantages	You bear the cost of borrowing (with interest, fees and time to apply).You are responsible for repaying your loan on time, and face penalties for late payment.You must meet the requirements of group membership (attend meetings on time, etc.) if the loan is through a group.	You have limited access to needed capital.Your business grows more slowly.You have limited ability to respond to opportunities.

Risks Associated With Borrowing

For every borrower, debt is a risk. If you can’t repay your loan, there will be consequences!  Even with careful planning, you may have problems making loan payments. Many unplanned events can turn this risk into reality, such as the following:

• When your income is interrupted due to illness or necessary absence
• When the investment of the loan results in a loss
• When your household and business expenses are greater than your income
• When unexpected events create an urgent demand for cash (e.g. to pay doctors’ expenses, funeral costs, etc).

Situations like these are common among the poor. Yet, loans must be repaid, regardless of the situation. If you face difficulties making your loan payments, what are your options?

To get the money for loan payments, you might need to reduce your spending or sell something of value.  You can ask your friends and relatives to help you, but there is a risk that you will eventually “use up” their goodwill towards you.

If you fail to pay altogether or default on your loan, what are the consequences?  You may lose access to sources of credit in the future.  You may strain relationships with other members of your credit group; you might suffer humiliation in the community and lose the goodwill of your friends and family.  Defaulting on a loan may damage your confidence and self-esteem.

Borrow wisely

The risks that come with taking a loan should make you think carefully about when and how much to borrow. Loans can open new doors, but you need to know when taking a loan is a wise decision. Good uses of loan capital include the following:

• Purchasing inputs in bulk at a lower price that will increase profits
• Financing productive assets such as machines that help you improve productivity, i.e., a water pump that enables an additional harvest or food-processing equipment that adds value to a crop.
• Purchasing an asset that makes a new business possible, such as a cell phone or a refrigerator
• Simply put, borrowing is good when it helps you gain financially and bad when it becomes a financial burden.

Use of the Debt	Good Debt	Bad Debt
Purchasing an asset or consumables	The asset or goods purchased outlast the time it takes to pay off the lender. The income earned from the asset exceeds the cost of the loan.	Debt is still owed after the item is consumed or the income earned from the asset is less than the cost of the loan.
Working capital	The loan makes it possible to pursue a business opportunity that is profitable enough to repay the loan and have something left.  The loan helps you save money on inputs or inventory and thus increases your earnings from the final product.	You cannot earn enough to repay the loan.You have other less-costly sources of financing.You cannot get the loan in time to take full advantage of a specific opportunity.
Emergency loan	The loan helps you solve an immediate problem without undue hardship.	The loan terms are too costly, or cannot be adjusted to your ability to repay.

To pay back your loan, you have to make the money work. Borrow for productive investments such as buying a piece of land where you can grow something or increasing your business. Payback the loan and maybe borrow more later if it is necessary. Use loans wisely and never rush into borrowing. Think twice before borrowing for luxuries or things that lose value (e.g. car, furniture, clothes, etc) except if they are meant to boost your income.

The Costs of Borrowing:

The main cost associated with a loan is the interest charged for the use of the money. This is usually calculated as a percentage of the total loan amount, and you typically pay it in monthly installments as part of your loan payment.  In addition, many lenders also charge administrative fees which you usually pay once, when you take the loan. Interest and fees are charges that you pay directly to the lender. These “direct costs” are usually cash payments.

However, there are other expenses associated with borrowing that may not be so obvious. Sometimes applying for and taking a loan forces you to spend money for transportation to attend meetings or go to the bank to fill out application forms.  These activities may take you away from your business, forcing you to close it or hire someone to “mind the store” while you are away. Although these additional “indirect costs” may not be part of the cash loan payment, they are real and should be considered when choosing a lender.

How much Debt can you afford?

Too much debt can cause serious problems. The term “over-indebtedness” refers to household debt that is too high relative to household income.  How do you figure out how much debt is too much?  Unfortunately, there is no rule of thumb about a safe debt-to-income ratio, although 20 to 30 per cent of household income is widely used.  

Should your household always avoid carrying more than one loan at a time?  Not necessarily, especially if you face a crisis and need cash urgently.

Before taking on a loan, you should consider both the costs and risks of borrowing. 

Answer the following questions based on your own circumstances:

• What percentage of my household and/or business budget can I afford to make available for debt repayment? 
• Will I have enough left over to adequately cover other household expenses?
• Can my guarantors afford to repay my loan? 
• How will they feel towards me if they have to do so?
• What are the consequences if I cannot repay my loan? 
• What is the value of the collateral (for example, a motorbike, house, etc) I have pledged?

As a borrower, the debt trap can sneak up on you.  Because it occurs slowly, you may not see it coming. Suddenly you owe more than you can afford to pay and the way out is nowhere in sight! The persistence of debt is one factor that keeps poor people in poverty. 

For most of us, living with debt has always been and continues to be a reality. Because your need for credit typically does not go away, you are likely to renew existing loans.  In fact, given ever-changing circumstances, at some point, you may need more than one loan at a time. This can happen when you are faced with an unexpected crisis and need cash urgently.

Important Credit Tips

• Create a budget: Creating a budget is one of the best things you can do for your financial situation, regardless of your income or debt. Trying to manage your loan without a budget puts you in a position of vulnerability and confusion you don’t always know where your money is going or how much of it is going there.
• Pay On time: Making your monthly payments on time every month is the best way to avoid late fees and penalties as well as hits to your credit score. These are unnecessary and all-too-common consequences that will work against your financial situation, so be mindful of them and do your best to stay on top of payments.
• Pay More than your minimum: Following the same strategy of making an early initial payment, it helps to pay more than your monthly minimum when you can. Paying a little extra each month keeps you ahead of your loan term as well as provide you with some other financial perks.
• Consolidate your loans: For borrowers managing multiple personal loans, consolidation could be a great way to simplify your debt repayment. Debt consolidation is when you take out a single, large loan that can be used to repay all of your other loans and debt. Then, instead of making payments to multiple lenders each month with different interest rates and requirements, you will be making a single payment to one provider.
• Keep An Eye on your Credit Score: Lastly, keep a close watch on your credit score while repaying a personal loan. Your credit score plays a big role in your finances and has an important relationship with the loans you take out—your credit score will affect and be affected by your loans.

The Bottom Line

 Debt is not our enemy. Bad credit habits are.  Use credit well and use it wisely

• It’s easy to get into debt but hard to get out. If you borrow money, plan carefully how you will use your loan and how you will pay it back – and stick to your plans.
• Don’t borrow because others are borrowing. It is not wise to take a loan just because other people around you are doing so.
• If you don’t pay back, you might lose your security. This can be your house, land, vehicle, animals or salary.
• Don’t “dig a hole” to fill up “another hole”. If you are already struggling with debts, avoid taking another loan since this will only add to your debts and hence increase your burden.
• Protect your financial image. Do not despair or lose hope if you have difficulties paying back your loan. Consult with family and friends on how to handle the situation.
• Keep your financial history clean. If you take a loan from a financial institution regulated by the Bank of Uganda, you will receive a financial card. With this card, your repayment history will be recorded… The better your history, the better the loan conditions will be.

Two simple rules will help you control your debt i.e. Do not borrow more than you can afford to repay and Save money regularly for emergencies so you do not always have to borrow.