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What is Debt? Understand the Pros and Cons

Debt is an important personal finance tool when used correctly. Learn more about the advantages and pitfalls that may come with debt.

What is Debt?

Have you ever borrowed lunch money from a friend with the promise of paying them back the next day? Missed a credit card bill? Took out a mortgage for a house? Then you’ve been in some sort of debt.

What is Debt?

Simply put, debt is money borrowed from another individual or institution with the intention of paying it back. Many individuals and corporations take out debt to pay for things they normally can’t afford, or if they can benefit from paying with debt rather than out of pocket.

How Debt Works

With most debt, there is a principal amount to be repaid at a later date, and an interest payment that occurs every period. For example, if you borrow $500 today for 2 years with an interest of 10% annually, you must pay $50 each year, and then pay back the full $500 by the end of 2 years, for a total of $600.

What is Interest?

Interest is the “cost of debt,” or extra money you are expected to pay for the ability to borrow money. This is paid to the lender for the risk they incur when they lend out their money.

Most debts will come with some form of interest, with many factors going into calculating interest rates.

This includes, but is not limited to:

  • The borrower’s risk of default (which means not being able to pay back a debt)
  • Length of borrowing
  • Government regulation
  • Inflation rates

Additionally, interest is paid every period you hold on to a debt, meaning the faster you pay it off, the lower your total interest expense will be.

Interest doesn’t just apply to debt. To read more about how interest rates affect bonds, click here.

Types of Loans

There are a variety of loans out there, including:

  • personal loans
  • student loans
  • auto loans, and more.

In all these varieties, an individual borrows money to pay for something that may be out of their budget at the moment. Depending on the loan, there may be different interest rates, repayment plans, and loan forgiveness.

However, in general, most people take out a pre-determined amount of money when taking out a loan, since they go towards specific expenses.

Mortgages

"A mortgage is a type of loan used to raise money to buy real estate."

The property being mortgaged is used to secure the loan, meaning that if the borrower doesn’t pay the mortgage or does not abide by certain requirements, the lender is legally allowed to take possession of the property and foreclose it.

A mortgage allows those who don't have the money to buy a property upfront to pay for the home in intervals (they are really paying off the loan). This makes homeownership accessible to more people.

As with other loans, you have to pay interest on a mortgage, called a “mortgage rate.”

Credit Card Debt

"When you don’t pay your credit card bill in entirety, credit card debt can accumulate." 

Credit card debt works similarly to loans, but are different in that the amount of debt isn't predetermined and can change regularly.

The amount of interest you pay depends on how much money you spend on the credit card and how much you repay each month.

Example: If you have a $1,000 balance on your credit card, and pay back only $100, the interest you owe will be calculated based off the $900 owed times your individual interest rate, whereas if you instead pay off the full $1,000 balance, you won't have to pay any extra interest.

Downsides of Debt

Debt makes it possible for individuals to afford things they typically couldn’t. However, it has a few disadvantages, which is why many financial advisors recommend you keep your debt to a minimum.

It's expensive

When you take out debt, you are also signing up to pay interest. Interest rates range from low to high, but they must be taken into account before taking out debt. Every period you hold onto debt, your interest payments are due, meaning if a debt is not repaid, your interest will continue to build up. This may eventually put people in a position where they owe much more than anticipated. Check out the next card, “What to do about Excess Debt,” to understand how interest, repayments, and time make a big difference.

It depletes your budget

Budgeting is already hard enough, and adding debt and interest payments will only leave you with less money to spend on other things. Financial advisors recommend not to spend more than 10% of your take-home income on debt and interest each month. However, this is just not feasible for people with lots of debt who don’t want it to accumulate.

It could give you a bad credit score

Not paying off a loan on time or going into credit card debt can negatively affect your credit score, which is a number that indicates the ability to repay loans to a lender. These repayments, or lack there-of, go into your “payment history,” lowering your score if they are not in on time. Also, even taking out a loan in the first place could affect your credit score, because the amount borrowed is added to the “amount owed” section of your score. This makes it harder to take more debt, like a student loan or mortgage later on, because it indicates you may be a riskier borrower. Also keep in mind that a good credit score usually translats into lower interest rates, meaning that loans are much cheaper in the long run for those who are better with their finances.

What to do about Excess Debt

Pay Above the Minimum

Say you have credit card debt, or are past your repayment date on a loan. The credit card company or your loan repayment plan may have you making really small minimum payments every month or year, which could seem like the better choice at the time (as everyone wants to pay less in the present), but putting down more money upfront may save you loads on interest payments in the long-run.

For example, if you are in $3000 of debt at 15% interest a year, and you plan to pay off $600 a year, it will take you 5 years to pay off, costing you $1350 in interest. More than a third of the original debt! Instead, if you paid $1500 a year, you would only rack up $675 in interest expense, half as much as the former plan. That's the difference between your total debt repayment being $4,350 vs. $3,675: massive savings. Therefore, if paying more upfront is a feasible option for you, it will definitely be a cheaper and better option overall.  

Steer Clear of New Debt

If you find yourself going into credit card debt often, it may be time to start using cash or a debit card for your purchases to avoid debt accumulation, and figuring out where you can cut back on spending. On the same note, if you aren’t able to make the repayments or interest payments for loans on time, it may be because you are spending in excess of income. Here is where budgeting, saving, and overall financial planning come into play. To learn how to reduce spending and plan for financial success, click here.

Consolidating Debt

If you have several lines of debt, you may be able to consolidate them with a single personal loan or line of credit.

What is Consolidating Debt?

To put it simply, consolidating debt means taking out a loan at a lower interest rate to pay off debts that have higher interest rates.

Why Consolidate?

In this way, you lower your interest cost, saving you money over time that can be further applied to paying off more of your debt.

Keep in mind that personal loans all come with different interest rates and requirements, meaning you have to compare and research which option is the best for your own personal circumstance.

Also, consolidating your debt means you are taking out a new line of credit, which may affect your credit score. 

Other Strategies to Consider

Debt Snowballing

This is a way to reduce your debt by tackling your smallest debts first. This method helps knock out interests payments on smaller debts so that you could repurpose that money to start paying off more of your bigger debts, until all your debts are paid off. To start, list out all your debts from smallest to largest. Pay the minimum repayment on all of the larger debts first, and then repay as much as you can towards the smallest debts. Once the smallest is paid off, repeat in order until all debts are repaid.

Debt Stacking

This method is very similar to debt snowballing, except generally you order your debts based on interest rates rather than the size of the debt. To start, pay off the debt with the highest interest rates first, and then repeat in order of highest to lowest interest rates until all of your debts are repaid.

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