Module 8 · Borrowing and debt
What is credit, and why does it cost money?
What borrowing really is, the four building blocks of every loan, why lenders charge interest, and what changes when a loan is secured.
This lesson is not translated into your language yet, so it is shown in English.
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In this lesson
- Explain credit as using someone else's money now and paying it back later, plus a price
- Name the four building blocks of a loan: principal, interest, term and collateral
- Explain the three reasons lenders charge interest: time, inflation and risk
- Tell secured from unsecured debt and say what a lender can do if you stop paying each
Ana and Bor walk into the same bank on the same day. Each asks for €5,000, to be repaid over 3 years, with nothing pledged. Ana is offered 4.5% a year. Bor is offered 10%. Same bank, same loan, same week — so why does Bor pay more than twice as much?
Credit means using someone else’s money now
is any arrangement where you get money, goods or services now and pay for them later. If a friend lends you €50 for a concert ticket and you pay back €50 next month, that is credit at no cost. A bank wants to be paid for lending. The money you owe at any moment is your debt.
Every loan is built from four parts:
| Part | Means | Example |
|---|---|---|
| the amount you borrow | €5,000 | |
| the price of borrowing, usually a yearly percentage of what you still owe | 4.5% a year | |
| Term | how long you have to repay | 3 years |
| something valuable you pledge, which the lender can take and sell if you do not pay | a flat, a car, a gold ring |
Interest is not a one-off fee. On most loans it is charged every month on the part you still owe. As you repay principal, the interest charge shrinks.
Why borrowing costs money
A lender asks for interest for three reasons:
- Time. While you use the money, the lender cannot use it for anything else.
- Inflation. Prices tend to rise, so €5,000 paid back in 3 years buys less than €5,000 today.
- Risk. Some borrowers never pay back. Lenders add a charge, called a risk premium, to cover these losses.
The first two are the same for everyone borrowing that day. The third depends on you. That explains Ana and Bor: the bank judged Bor more likely to miss payments, perhaps because of late payments in the past. If the risk looks too high, the lender says no.
Inflation also changes what a loan really costs. If your rate is 5% and prices rise 3% a year, your is about 5% − 3% = 2%. If inflation jumps to 8% while your rate stays fixed at 5%, the real rate turns negative: the euros you repay are worth less than the euros you borrowed.
Secured and unsecured: what happens if you stop paying
A is backed by collateral. Home loans are secured on the home, and many car loans on the car. If you stop paying, the lender can, through a legal process, have the asset sold to get its money back. Because the lender expects to lose less, secured loans are usually cheaper.
An has no specific asset behind it — only your promise and your income. Most personal loans, credit cards and overdrafts are unsecured, and they cost more. If you stop paying, the lender must chase you through reminders, debt collectors and the courts. In the end a court can let it take part of your wages or bank balance.
“Good debt” and “bad debt” is only a shortcut
People often call debt for education, a home or a work tool “good debt”, and debt for holidays or gadgets “bad debt”. The idea is rough. A degree can become a burden if it costs far more than graduates in that field earn. A modest car loan that lets someone keep a job can be sensible, even though cars lose value.
Better questions than “good or bad?”:
- Do I know the total cost in euros?
- Could I still pay if my income fell or the rate rose?
- What happens if things go wrong?
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