You and your money
You and your money

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3 Debt costs

3.1 Some basics of debt and interest

When someone acquires a debt, the money that they will have to repay to the lender will consist of three different elements. Let’s briefly introduce each of these in turn.

First, there is the amount originally lent – this is normally referred to as the principal sum (or sometimes the capital sum). For instance, if £10,000 is borrowed for five years to buy a car, then the £10,000 will have to be repaid. There are two usual ways in which this principal sum can be repaid: either in one amount at the end of the term of the loan (in this case, five years), or in stages over the life of the loan. The former is often referred to as an ‘interest-only loan’ and the latter a ‘repayment loan’. If the principal sum is to be paid off in full at the end of the loan period, the borrower will need to have the money available – for example, through the proceeds from an endowment mortgage or through building up other savings to pay off the loan.

Second, there is the important additional cost of having debt: the interest that has to be paid on it. In effect, interest is an additional charge on the repayment of debt. The interest rate is the exact price of this charge. It is normally expressed as a percentage per year – for example 7 per cent per annum, or more commonly abbreviated to ‘7 per cent p.a.’. The charging or paying of interest is generally rejected by shariah law, as it used to be by some Christians in earlier centuries. In modern economies, the concept of interest comes about because lenders require payment in return for the access to the money they have given up, in return for the risk associated with not getting their money back, and because they require an amount to cover the expected inflation rate over the coming year.

Third, there may be charges associated with taking out, having or repaying debt. We’ll look at these in more detail in Section 3.4.

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