There of course will be challenges to reaching your financial goals and one of the biggest ones that prevents people from reaching those goals is runaway debt.
“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
Debt isn’t necessarily a bad thing. Borrowing money to buy a car might be necessary for you to accept a job that isn’t very close to your home. And as we’ll see, borrowing money to buy a home gives you the security of a place to live plus a home can turn into a very good investment over time.
But it’s when people live beyond their means and use expensive debt, like credit cards, that they often get themselves into deep trouble.
Let’s look more closely at different kinds of debt…
Key Concept: Loans and Mortgages
A loan is an agreement between someone borrowing money and someone lending money on how that loan will be paid back over time and what the cost of borrowing the money will be. Loans can take different forms. We’ve mentioned car loans and mortgages or house loans, but there are many other kinds of loans.
(Interesting fact - the term “mortgage” comes from a French term meaning “death pledge”. Read into that what you will.)
But credit cards are also a type of loan, buy-now-pay-later services are loans, you can get personal loans, home improvement loans, small business loans, and more.
Loans have a few key terms: the amount being borrowed, the term of the loan (that is, the time to repay it fully), the payment frequency (usually monthly), and the interest rate (quoted annually, but it can be effectively higher due to monthly compounding).
Comparison of loans, payments, and total interest paid
| Example | Amount | Term (years) | Interest rate | Monthly payment | Total interest |
|---|---|---|---|---|---|
| Student loan | 40,000 | 10 | 6.0% | 444.08 | 13,025 |
| Car loan | 30,000 | 5 | 6.0% | 579.98 | 4,626 |
| Mortgage | 250,000 | 30 | 6.0% | 1,498.88 | 286,911 |
| Mortgage | 250,000 | 15 | 5.5% | 2,042.71 | 116,010 |
| 15 v. 30 Savings | 170,901 |
Here are some examples of loans. The monthly payment is determined by the amount of the loan, the term, and the interest rate. There is a mathematical formula for determining the monthly payment that you’ll find on calculators and in Google Sheets or Excel called PMT for “payment”.
It’s a little more complicated than just calculating the interest and dividing by the number of pay periods because as time goes on, the amount remaining on the loan will go down. But dealing with a monthly mortgage or car loan payment that changes each month is complicated, especially if you want to set up automatic payments, which banks prefer. So there is an amortization formula that solves for this to produce a constant payment where the interest and principal vary over time.
Note in the table the two mortgage examples at the bottom. This is an example of a choice you might have when you are buying a house. Typically, you’d take out a 30-year loan. But if you are willing to take out a shorter-term loan, in this case, 15 years, you can usually get a slightly lower interest rate. So in this example, the monthly payment is about $500 more but over the full life of the loan, you’ll save over $170,000 in interest payments.
Debit Cards vs. Credit Cards
| Debit Cards | Credit Cards | |
|---|---|---|
| Interest Charges | no | paid on outstanding balance |
| Funding | linked to bank account | line of credit (loan) |
| Purchase Protection | limited/none | yes |
I’ve mentioned credit cards a few times and you’ve seen them used a lot, but you are more familiar with debit cards so let’s explain how they differ.
A debit card is used to pay for things by taking money directly out of your checking or savings account. Each time you use it, a deduction is made immediately from the linked account. You don’t have to “pay off” debit cards because you are paying for things as you go. If you don’t have money in your account to cover the item, the transaction is denied. You don’t ever go into debt so there’s nothing to pay off.
A credit card, on the other hand, is a way to borrow money from another company - the card issuer. When you buy something with a credit card, the issuer is actually paying the merchant for the item and lending that amount to you. Over time, you build up a balance which is just a loan. When you make a monthly payment on a credit card, you are paying down some of that loan, including interest in most cases.
The real cost of buying with credit
Earlier we mentioned the potential danger of overextending yourself with credit card debt. There are three real reasons this is such a problem:
- The interest rates are very high, often 15% to 18% per year.
- Credit card companies make it very easy for people to get cards (because they are so profitable for the issuer). So people often have five or more credit cards.
- The credit card companies also make it easy to continue to carry large balances by requiring only a very small minimum payment each month (as little as 1% of the balance).
If you had 5 credit cards with an interest rate of 18%, and each with a balance of $10,000 you’d be paying $750 just in interest each month! With such high-interest expenses, it’s difficult to ever pay the balances down. This is the trap some people get themselves into.
Here are some examples of the true cost of buying something on a credit card if you only made the minimum payment each month (a typical amount is $15). A $100 item would only cost you an additional 6% in interest, although it would take 8 months or over half a year to fully pay off.
| Balance | Total interest | Pct of balance | Months to pay | Years to pay |
|---|---|---|---|---|
| 100.00 | 6.16 | 6% | 8 | 0.7 |
| 500.00 | 198.36 | 40% | 47 | 3.9 |
| 1,000.00 | 923.16 | 92% | 113 | 9.4 |
| 5,000.00 | 6,923.17 | 138% | 273 | 22.8 |
But as the amount goes up, the additional interest as a percent of the purchase price gets larger and larger, sometimes even exceeding the original price of the purchase. And it can take many years to fully pay it off. Just think if you bought a $1000 laptop and it took you over 9 years to pay it off but the laptop only lasted 3 years!
The high cost of too much debt
Maybe a more realistic example of the dangers of too much debt, is someone who makes $100,000 a year, has a $150,000 mortgage, a $40,000 car loan, and $25,000 of credit card debt.
| Category | Breakdown |
|---|---|
| Income | 100,000 |
| After taxes | 75,000 |
| Monthly net pay | 6,250 |
| Loan | Balance | Payment | % of net pay | Interest |
|---|---|---|---|---|
| Mortgage | 150,000 | 899.33 | 14.4% | 11.7% |
| Car loan | 40,000 | 773.31 | 12.4% | 2.1% |
| Credit cards | 25,000 | 625.00 | 10.0% | 6.0% |
| Total | 2,297.64 | 36.8% | 19.8% |
Note how this person would be spending over a third of their take-home pay on loan payments, making it almost impossible to live within the budget goals we talked about earlier. And this is before even paying for mandatory expenses like utilities and groceries. In this case, if the person is two years into both the car loan and mortgage, the interest alone is 20% of their net pay, which is the same amount they should be targeting for saving and investing.
The best way to avoid this trap is to be very careful about taking on debt in the first place.