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Debt Basics

I often hear the topic of explaining debt as “good” or “bad” based on the type of debt. In my opinion, it was your decision to purchase something which resulted in you taking on debt that is considered good vs. bad. Once you hold a debt balance, the decision to pay it off or keep that loan should be based on the cost of carrying that debt, and the opportunity cost associated with paying it off.


To determine the structure of your debt, the few features that you should know about include:


Principal - the original / current balance of the loan.

Interest - the cost of borrowing in the form of an annual rate (%) - this can either be fixed (same rate throughout the loan) or variable (can change throughout the loan).

Term - some debt has a set term (like a mortgage) and some is revolving, with no set term.


A few items to call out: almost all debt can be considered below with the exception of federal student loans - as far as I know, a federal student loan is the only debt that can have a payment based on your income as opposed to the three variables mentioned above.


Second, for purposes of this discussion I am using loan and debt interchangeably. There is debt out there, like large sums of medical or personal debt, that are not on a payment plan and will need further action to resolve (e.g. bankruptcy, offer in compromise, etc.). This blog will not be helpful for those in that situation, as not much can be done at that point other than working with a qualified attorney to help you settle your debts. My hope in spreading financial education is to plan ahead and avoid ever getting into that situation.


Some of the common debts I can think of that are relevant to my discussion are:

  • Mortgage

  • Credit Card Debt

  • Car Debt

  • Medical Payment Plan (Care Credit)

  • Personal Loan

  • Private Student Loan (not Federal)

Principal


This is the starting amount of your debt - how much did you borrow? This number is self explanatory and is always the starting point in calculating your payment and interest expense. This is the total amount to pay off, which will cost you interest along the way.


When you make a debt payment, that payment always starts with paying for the interest due, followed by the principal. Therefore, if you do not make a large enough payment to cover the interest, the principal amount will not change and may even increase if you do not pay the full cost of interest when due.


Getting ahead of myself, but it is important here - interest can be considered compounding interest or simple interest, and most debt types from what I have seen are compounding. Compounding interest works against you - if you do not cover the interest cost, the remainder gets added to the principal, and you pay interest on both the principal and the added interest…. creating a snowball effect on your debt. Make sure you are at least covering your interest costs with this type of debt.


If the interest is not compounding, then it is considered “simple” where any unpaid debt does not get added to principal, and interest continues to be calculated on the remaining principal amount not including the unpaid interest. Any payments will have to cover the full interest due before paying down principal. One thing to be aware of here is if that simple interest can be capitalized. Capitalization is when at some point in time, or due to a certain event, the unpaid interest gets added to the principal amount and you begin paying interest on that full amount (similar to compounding).


If you pay more than the interest each time a payment is due, your principal gets paid down and if you pay less, your principal and debt balance grows, resulting in what is called “reverse amortization”.


Interest Rate


As mentioned above, there are two ways that interest is charged; either compounding or simple.


There are a couple other factors to consider here. The interest rate is the cost of carrying the debt, presented in an annual percentage rate, but may be charged on a separate schedule (e.g. monthly).


There is some debt that may be deductible on your taxes, including student loans and a mortgage, each subject to its own rules and limitations. But this is a consideration when determining the true cost of carrying that debt. Personal loans, car debt, and credit cards are not deductible expenses, and you must pay the full cost of the interest associated.


Another consideration with interest rate is if it is fixed or variable. If the rate is fixed, you can rest assured that the interest cost will remain the same (in % terms) throughout the life of the loan. If it is variable or has the ability to change, this is something to consider. Make sure you understand how much / how often it can change and what can influence a change, so that you are ready to refinance or pay off the debt in the instance the interest rate increases more than you are comfortable with.


Refinancing is an important concept to understand when it comes to debt. This is basically the act of borrowing money from a new lender, and using that new money to pay off the other lenders. In the simplest terms, it is swapping one debt for another. The reasons to do this are:

  1. It may consolidate a few loans into one lender, resulting in paying attention to only one debt and making only one payment. This simplifies the debt.

  2. Getting a lower interest rate and reducing the cost of borrowing. Make sure you are comparing the “true” cost (after tax deductions) before making the decision. Also, typically it will cost you a loan origination fee, or other fees from the new lender to do this. Make sure the interest savings is worth the cost of refinancing.

Interest can be seen as the cost of carrying the debt, and should be accounted for when figuring the total cost of the original purchase.


Term


The final determinant of debt is the term. This is the time period that the debt must be repaid, or refinanced by. Many debts, as a result of asset purchases (car, home) have a set schedule, and thus a stagnant monthly payment until the debt is paid off.


Other loans, like personal loans or credit card debts, do not work on a time schedule. They have a minimum payment amount typically, but that will not determine how long it will take you to pay off the debt. This form of debt can also be called “revolving credit” and can continuously be borrowed on as needed. Revolving credit can be dangerous and should not be taken lightly - make sure you understand the debt and can responsibly control it before taking this on.


Conclusion


Debt can be used as a tool, and as long as you understand it, you should make sure you are putting yourself in the position to be able to manage the debt.


There are a few basic features that go into every type of debt that can help you determine how long you may hold the debt, how much it will cost you, and what you will be paying each month towards the debt. These are very important in determining the affordability of what you are purchasing and if it makes sense to take out a loan in order to make that purchase.