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About 7 minutes
First things first, we should probably start off with some terminology to make sure we’re all on the same page. If this is too much of a review for you, feel free to scroll onward excitedly.
Debt, as you might already know, is borrowed money. And it can come in various shapes, sizes, and colors (well, not so much colors). If you borrow money to, say, go to school or to buy a home, the money you owe is debt.
Debt is also considered a kind of liability, which is any financial obligation or commitment that needs to be paid in the future. Liabilities are the opposite of assets, which store and generate wealth, which we covered in Setting Goals.
When you take on debt, the amount of money you borrow is referred to as the principal, or your outstanding balance. And the cost of borrowing is represented by the interest. If you need a refresher on interest rates, take a look at the section on Compound Interest.
How is debt created in the first place?
Good question. It’s a little complicated, but basically this happens when a person or an institution (aka a bank) lends money to another person or institution. We say that the creditor (fancy word for lender), is extending credit to the debtor (fancy word for borrower). In doing so, the lender is trusting the borrower to repay the debt under the agreed upon terms. This trust is referred to as credit and is the topic of the next section.
Typically, a bank will serve as the middleman in the process by taking deposits from people who have savings and making loans to people or companies who need the money.
Speaking of loans
The basic type of consumer debt is, you guessed it, a loan.
The terms of the loan will be written in a legally binding contract, called a loan agreement. This spells out the specifics, like how much has been borrowed, when it must be repaid by, and what the interest rate will be.
Some loans, including most mortgages and student loans, require the principal to be amortized, or paid back in increments over time (rather than all at once at the end). When that’s the case, the loan agreement will spell out the amortization schedule, or repayment schedule, of the loan. This means part of your monthly payment goes toward interest and part of it goes toward paying down the principal balance.
While these are a few of the important details of a loan agreement, there are a lot more. So you’ll want to make sure you understand the terms before signing. If you don’t live up to them, you’ll be said to be in default, and the lender will have the right to pursue legal action to force you to comply. Not a good situation to be in.
“Good” vs “Bad” debt
As a borrower, your focus will likely be on consumer debt, which includes things like credit card debt, student loans, home mortgages, and auto loans.
But not all debt is created equal.
For the most part, credit card debt and other kinds of personal loans, like pay day loans, are usually considered “bad” debt, and for good reason. They tend to charge really high interest rates, often as much as 20% (or even more). And they also tend to “offer” fairly low minimum payments to encourage you to pay it off slowly.
On the other hand, some types of debt, like student loans and home mortgages, are sometimes considered “good” debt because they tend to charge lower interest rates and may actually help you build wealth over time, if used appropriately.
Note that we said appropriately. Yes, the interest rate is a defining characteristic. But any debt can become a problem if it gets out of hand, even so called “good” debt. If you borrow too much for a home that you really can’t afford or if you borrow to pay for an education but still can’t find a job, you can still run into financial trouble. No debt is good if it leads to unmanageable payments that drain your finances.
Comparing loans with APR
When you’re in the market for a loan, you’ll certainly want to pay attention to the interest rates offered by competing lenders. But that’s not the end of the story. There will likely be additional fees and charges. And this can make it hard to tell which offer is actually the best deal.
So to help make it easier to do an apples-to-apples comparison, lenders are required to give you something called an Annual Percentage Rate, or APR.
The exact math for calculating an APR is a little tricky. However, the basic idea is to start with the interest rate, then add any fees or closings costs associated with the loan, and express it all as an annual rate. This gets you to a single number you can more easily compare from one lender to the next.
But even after comparing APRs, you’ll still want to consider all aspects of the loan, like the interest rate and closing costs. And of course don’t hesitate to ask about any fees you don’t understand.
Financing a purchase
Some purchases in life are so big it would be impossible for most of us to pay for them entirely with cash. For example, buying a home. For smaller purchases, financing might also be available, but you should always consider the total cost before borrowing.
Say you’re interested in buying a new TV for $1,000. One option is to pay for it in cash, and if you do, you’ll know exactly how much you’re paying: $1,000 (plus sales tax maybe). However, you might not have $1,000 burning a hole in your pocket right now, AND the store might offer a financing plan. Hm, a tempting offer indeed. Hm.
Suppose the store offers you a three year financing plan, with LOW LOW LOW monthly payments of just $50. Wow! What a deal. You mean I don’t have to shell out $1,000? Well, not so fast partner. Although you may save a little money today, you’ll actually end up paying more over the long run. A lot more. Over three years, that $50 a month will come out to $1,800, a little less than two times the original price. Not a great deal when you put it like that. Maybe there is something to this saving thing after all.
No interest. Period?
But what if the store offers a no interest period, meaning you can pay later and won’t owe any interest for a specified period of time. Okay, this is not necessarily a bad idea, as long as you pay in full before you start paying interest.
But you NEED to pay off your balance before the no interest period ends. Otherwise, the cost will start to increase. And if you miss a payment, you may end up owing back interest, which will add to the cost significantly. It simply might not be worth taking the chance.
Some stores also offer rent-to-own options, but these are essentially the same as financing. The total amount you’ll end up paying is typically much more than the original purchase price. Additionally, if you can’t make your payments, the store can take back the purchase and you’ll be left with nothing for the previous payments you’ve already made. And who likes being left with nothing?
Borrowing. Not just for individuals
Borrowing money isn’t limited to individuals. Businesses and governments borrow money too. In fact, they borrow quit a bit of money. The U.S. Government alone has over $20 trillion in debt outstanding. That’s Trillion…with a capital T…and a lowercase ‘rillion.
When businesses and governments need to borrow, they typically do so by issuing bonds, which can be purchased by investors. In the same way a bank will assess your personal credit before giving you a loan, bond investors will also assess the credit of businesses and governments. We’ll cover bonds from the perspective of an investor in more detail in the sections on investing.
Look before you leap
As you know by now, we aren’t here to tell you what to do with your money, what to buy, or what to invest in. And borrowing isn’t necessarily good or bad, but it’s important to understand what you’re getting into and to be aware of the ultimate cost to you before you take on a loan or enter into a financing agreement of any kind.
In the upcoming sections, we’ll cover credit and managing your debt in more detail.
1) Debt is a type of liability, which is anything that needs to be paid in the future. The basics form of debt is a loan, like a student loan or home mortgage.
2) Some types of debt tend to be considered “good” if they charge relatively low interest rates and help to build your wealth, however any debt can be bad if it gets out of hand.
3) For the most part, high interest rate debt, like credit card debt, is generally considered “bad” debt and should be avoided and paid down.
4) When comparing loans, you’ll want to consider the interest rate, but you’ll also want to pay attention to the APR, which takes other ongoing fees into account, as well as any additional upfront fees and costs.
5) Just because financing options are available when making a purchase, doesn’t mean it’s a great idea. You’ll usually end up paying a lot more in the long run because of the interest you’ll end up paying.
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