Understanding Debt
Know Your Enemy (and Sometimes Your Friend)
Introduction
Debt is often vilified, but the reality is more nuanced. Some debt can help you build wealth, while other debt can destroy it. Understanding the difference—and how interest works—is crucial for making smart financial decisions.
In this lesson, we'll explore the nature of debt, distinguish between productive and destructive borrowing, and understand how compound interest can work against you.
What Is Debt?
Debt is simply money borrowed that must be repaid, typically with interest. When you take on debt, you're essentially spending future income today.
Key Components of Any Debt:
| Component | Description |
|---|---|
| Principal | The original amount borrowed |
| Interest Rate | The cost of borrowing, expressed as a percentage |
| Term | The length of time to repay |
| Monthly Payment | Regular payment amount |
| Total Cost | Principal + all interest paid over the life of the loan |
Good Debt vs. Bad Debt
Not all debt is equal. The distinction matters enormously for your financial future.
"Good" Debt
Debt that helps you build wealth or increase earning potential:
- Mortgage: Builds equity in an appreciating asset (historically)
- Student loans: Increases earning potential (if degree leads to higher income)
- Business loans: Funds income-generating activities
- Investment property loans: Creates rental income and appreciation
Characteristics of good debt:
- Low interest rates (typically under 7-8%)
- Funds assets that appreciate or generate income
- Tax-advantaged in some cases
"Bad" Debt
Debt that finances consumption or depreciating assets:
- Credit card debt: High interest, funds consumption
- Payday loans: Extremely high interest, predatory terms
- Auto loans for expensive cars: Depreciating asset, often high rates
- Personal loans for consumption: No asset value created
Characteristics of bad debt:
- High interest rates (15%+)
- Funds purchases that lose value
- No tax benefits
- Often for things you can't afford
How Interest Works Against You
When you borrow money, interest is the cost you pay for using someone else's money. With debt, compound interest works against you.
Simple Interest Example:
Borrow $10,000 at 5% simple interest for 3 years:
- Interest: $10,000 × 0.05 × 3 = $1,500
- Total repayment: $11,500
Compound Interest Example:
Borrow $10,000 at 5% compound interest for 3 years:
- Year 1: $10,000 × 1.05 = $10,500
- Year 2: $10,500 × 1.05 = $11,025
- Year 3: $11,025 × 1.05 = $11,576
- Total repayment: $11,576
The difference seems small here, but with higher rates and longer terms, compounding becomes devastating.
The Real Cost of Credit Card Debt
Credit cards typically charge 20-25% APR, compounded daily. Let's see the true cost:
Scenario: $5,000 credit card balance at 22% APR
| Payment Strategy | Time to Pay Off | Total Interest Paid |
|---|---|---|
| Minimum payment only | 20+ years | $8,000+ |
| $150/month | 4 years | $2,200 |
| $300/month | 1.7 years | $800 |
Paying only the minimum, you'd pay more than $8,000 in interest on a $5,000 purchase—more than the original amount borrowed!
Credit Card Interest Calculation:
Credit cards use daily periodic rates:
- 22% APR ÷ 365 days = 0.06% daily rate
- On a $5,000 balance: $3.01 in interest per day
- That's $90 in interest in just one month
Types of Interest Rates
Understanding interest rate terminology helps you compare debt options:
Fixed Rate
- Stays the same throughout the loan term
- Predictable payments
- Common for mortgages, auto loans, personal loans
Variable Rate
- Changes based on market conditions
- Payments can increase over time
- Common for credit cards, HELOCs, some student loans
APR vs. Interest Rate
- Interest Rate: The base cost of borrowing
- APR (Annual Percentage Rate): Includes interest rate plus fees, giving a more complete picture of the cost
Always compare APR rather than just interest rates when evaluating loans.
Common Types of Debt
Credit Cards
- Revolving credit with high interest rates (15-25%)
- Minimum payments keep you in debt for decades
- Convenient but dangerous if not paid in full monthly
Student Loans
- Federal loans have fixed rates and flexible repayment options
- Private loans may have variable rates and fewer protections
- Consider income potential of your degree vs. loan amount
Auto Loans
- Typically 4-7% for good credit, higher for poor credit
- Cars depreciate rapidly—avoid being "underwater" (owing more than car is worth)
- Consider buying used to avoid steepest depreciation
Mortgages
- Largest debt most people take on
- Currently around 6-7% for 30-year fixed
- Interest is often tax-deductible
- Build equity over time as you pay down principal
Personal Loans
- Unsecured loans for various purposes
- Rates vary widely (6-36%) based on credit
- Better than credit cards for large purchases if rate is lower
Payday Loans
- Extremely predatory—often 400%+ APR equivalent
- Designed to trap borrowers in cycle of debt
- Avoid at all costs; almost any alternative is better
The Debt Spiral
Debt becomes dangerous when it spirals out of control:
- Initial borrowing - Seems manageable at first
- Minimum payments - Pay mostly interest, little principal
- New expenses arise - Add more debt to handle them
- Stress and avoidance - Stop looking at accounts
- Compounding takes over - Debt grows faster than payments
- Crisis point - Collections, credit damage, or bankruptcy
Breaking this spiral requires confronting the situation, stopping new debt, and implementing a payoff strategy (covered in the next lesson).
Warning Signs of Too Much Debt
Recognize these signs that debt is becoming a problem:
- Only making minimum payments
- Using credit cards for necessities (groceries, gas)
- Balance increasing despite payments
- Taking new debt to pay old debt
- Hiding debt from partner or family
- Anxiety when thinking about finances
- Calls from creditors or collection agencies
- Debt-to-income ratio above 40%
If you recognize these signs, take action now—the longer you wait, the worse it gets.
Key Takeaways
- Debt can be "good" (builds wealth) or "bad" (destroys wealth) depending on what it finances
- Good debt has low interest rates and funds appreciating assets or income-generating activities
- Bad debt has high interest rates and funds consumption or depreciating assets
- Compound interest on debt works against you, especially with high rates like credit cards
- Credit card minimum payments can result in paying more in interest than the original purchase
- Recognize warning signs of too much debt early and take action before the spiral accelerates
Summary
Understanding debt requires distinguishing between productive borrowing (mortgages, reasonable student loans) and destructive borrowing (high-interest credit cards, payday loans). Interest compounds against you with debt, making high-interest debt particularly dangerous. Credit card debt at 20%+ APR can result in paying double or triple the original purchase price if only minimum payments are made. Know the types of debt available and their typical interest rates. Recognize warning signs of excessive debt and take action before the debt spiral becomes unmanageable.