Debt
What is Debt?#
Debt is money borrowed by one party from another. Debt is used to buy things you otherwise couldn't afford on your own. You borrow $5 from a friend to buy a drink. You are in debt1. You take out a loan to pay university tuition. You are in debt. You get a mortgage to pay for a house. You are in debt. You borrow money using a credit card. You are in debt.
The word "debt" probably has a negative connotation for most of us. Nobody wants to owe anyone money. Debts with high interest rates can be a dangerous thing. You'll end up owing way more money than you initially borrowed. Not all debt is bad though. Taking on debt with a reasonable interest rate can sometimes be a good way of purchasing something you don't have the money for right now. It can also be good if you're buying an asset, something that could earn you money or decrease your expenses.
How does Debt Work?#
You don't get to borrow money for free. The principal, the total amount you borrowed, has to be paid back by a certain date. The time period you have to pay back the debt is referred to as the term and is usually measured in months. In addition to the principal, you'll likely owe interest as well, which is the cost you pay for borrowing someone else's money. Just like the interest you earn from keeping your money in a bank account, loan interest is generally expressed as an annual percentage rate (APR). You usually work to pay off your debt in monthly payments.
The interest you have to pay could accrue simply or be compounded, and depending on which type of interest your loan uses, there could be a pretty big difference in the amount you end up paying. Simple interest means you are only paying interest on the principal whereas compound interest means you are paying interest on both the principal and the accumulated interest. In most cases, when we talk about interest, we're generally referring to compound interest.
caution
All this basic information must be made known to you as a borrower as stated by the Truth in Lending Act (TILA). Make sure you know the terms of agreement before borrowing money.
All this terminology can be confusing on its own, so let's understand how this works with examples. These examples will seem pretty similar to examples in the Credit section since credit card debt is a subset of debt.
tip
The goal of these examples is not to make you memorize equations but to gain a more concrete understanding of these concepts. In fact, no equation will be given to you. Focus on the concept and not the math.
Simple Interest Example#
You took out a $10,000 for 3 years at 5% APR. Breaking that down:
- Principal = $10,000
- Interest rate = 5% yearly
- Term = 3 years
In other words, for interest each year, you have to pay 5% of $10,000 which is $500. $500 a year for 3 years is $1,500. Since you have to pay back both the principal and interest, you're paying a total of $11,500.
Compound Interest Example#
You took out a $10,000 for 3 years at 5% compounded annually. Breaking that down:
- Principal = $10,000
- Interest rate = 5% yearly
- Term = 3 year
For interest the first year, you have to pay 5% of $10,000 which is $500. At the end of the first year, you will owe a total of $10,500.
For interest the second year, you have to pay 5% of $10,500 which is $525. See where this is going? You have to pay interest on interest. At the end of the second year, you will owe a total of $11,025.
Finally, for interest the third year, you have to pay 5% of $11,025 which is $551.25. So, at the end of the three years, you owe $11,576.25.
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It's worth noting that interest can compound multiple times a year. We won't go over an example to keep things simple, but if you see that your interest compounds quarterly, monthly, or some other variation of multiple times a year, you will owe more interest than if it were to just compound yearly.
Simple vs. Compound Interest Examples#
In the simple interest example, we paid $11,500. In the compound interest example, we paid $11,576.25. Even though $76.25 doesn't seem like that much, imagine if you borrowed more money, borrowed at a higher interest rate, or borrowed money for longer. This interest you have to pay back can grow to be a pretty big amount.
Strategies for Paying Off Debt#
There are a couple of strategies when it comes to deciding which of your debts to pay off first: the debt avalanche and the debt snowball methods.
Avalance Method#
The debt avalance method calls for paying off debt with the highest interest rate first. After paying all of your necessary bills like food and housing, let's say you have $1,000 left to spend each month. Your loans include:
- Loan 1: $3,000 loan with 10% APR with a minimum monthly payment of $300
- Loan 2: $1,200 loan with 5% APR with a minimum monthly payment of $100
First, you would make the minimum monthly payment required by each debt to remain in good standing, so you first pay $400. Then, you would put your remaining $600 towards paying off Loan 1 since it has the highest interest rate at 10%. Once you pay all of that debt off, you move on to pay off Loan 2.
With the avalance method, you will minimize the amount of interest you pay and lessen the total amount of time it takes to get out of debt.
Snowball Method#
The debt snowball method calls for paying off debt with the lowest balance first. Taking the same example, suppose you have $1,000 left to spend each month and your loans include:
- Loan 1: $3,000 loan with 10% APR with a minimum monthly payment of $300
- Loan 2: $1,200 loan with 5% APR with a minimum monthly payment of $100
First, you would make the minimum monthly payment required by each debt to remain in good standing, so you first pay $400. Then, you would put your remaining $600 towards paying off Loan 2 since you only owe $1,200 on that debt, compared to the $3,000 you owe for Loan 1. Once you pay off Loan 2, you move on to pay off Loan 1.
With the snowball method, you might be more motivated because you can pay off smaller debts first, and you might have some extra cash each month since you'll have fewer minimum monthly payments to make. However, larger loans, which might have a higher interest rate, are left unpaid for longer which costs more in the long run.
Which Method is Better?#
The avalanche method is always the better method since you're paying less than the snowball method. It can be difficult to stick with it though, so you might be more motivated with the snowball method.
Summary#
- With debt, you have to pay off the original amount you borrowed plus interest by a certain time.
- Interest can be accrued simply or compounded. Compound interest will end up costing you more than simple interest.
- The avalanche method (paying off debts with higher interest rates) is the best way to pay off your debts.
- If they're a real friend, you wouldn't be in debt 😉↩