Debt: what is it?

When managing one’s finances, most financial advisors recommend that one avoid taking on debt or prioritize paying existing debt down as quickly as possible. But, what is debt? I find that a lot of young people I speak with don’t actually understand what debt is. Today’s post is to explain what debt is, provide examples of common types of debt and why a good rule of thumb for managing finances is to minimize or avoid it.

What is debt?

Debt is just a fancy name for money that you borrow. You typically borrow that money from financial institutions such as a bank, savings and loan or credit card company.

The principle is simple, the institutions lend you money for whatever specified need you have. In return, those institutions have an expectation that you will repay the money you borrowed, along with sufficient interest for them to cover their risks and make a profit.

What are some common examples of debt and how do they work?

There are many different ways to borrow money. The following are common examples, but this is not an exhaustive list. Please note that I will make the assumption that you make all of your payments on time as I describe how that type of debt works:

• Credit cards: when you buy something with a credit card, you are borrowing money from the card issuer to make that purchase. You will need to make payments to the lender each month to cover your borrowings, but you get to choose how much of the balance you will pay, subject to a minimum payment amount. If you pay your balance in full, you won’t get charged any interest in the next billing period. If you pay only a portion of the balance, the remainder gets carried over to your next month’s bill and your card issuer will charge interest on that debt. Credit card interest rates tend to be very high as they are unsecured loans — the bank doesn’t require you to provide collateral which they can seize if you default on this debt. Because this type of debt is riskier for the lender, they charge a higher interest rate to cover that added risk
• Mortgage: a mortgage is money you borrow to buy a house or other property. For most mortgages, you will need to make a payment each month which covers the interest on your outstanding loan amount (your principal on the loan) and also to pay down a portion of the principal. If you default on the mortgage, the bank will foreclose upon and take over the property with which this debt is secured. These are secured loans as the property is collateral which you have pledged to secure the loan. As such, mortgages should have lower interest rates than unsecured loans
• Student loan: these are borrowings which are made to support the costs of education. Similar to a mortgage, you will need to make a payment each month which covers the interest on your outstanding loan amount and also to pay down a portion of the principal. While these are unsecured loans, they are generally not dischargeable in bankruptcy so their interest rates are more moderate than other unsecured loans
• Business loan: these are borrowings which are made for setting up or funding ongoing operation of a business. Similar to a mortgage, you will need to make a payment each month which covers the interest on your outstanding loan amount and also to pay down a portion of the principal. These may or may not be secured loans so their interest rates depend on the specific terms of the loan
• Auto loan: Very similar in concept to a mortgage, these loans are for purchasing a vehicle which serves as the collateral for that loan. Repayments cover the interest on your outstanding loan amount and also pay down a portion of the principal. Unlike a mortgage though, auto loans are for depreciating property as car values go down over time while property values generally appreciate. Therefore, as the collateral is less valuable, these loans tend to have higher interest rates. However, for new cars, automakers will often subsidize the interest rate as a tool to get you to buy their product
• Payday loans: These are very short-term borrowings that people use to get past emergency needs for money. They charge high interest rates with very short terms such as several weeks. In many states, their interest rates have become more regulated as they have historically been incredibly high and lead many people who borrow with them on an unending debt cycle

Why is it best to avoid most types of debt?

In addition to having to repay the money that you borrowed, debt has costs that you will need to bear over the lifetime of your borrowings:

• Direct cost of the interest on your loan: Any money you have to pay in interest is money that you don’t have for other uses. For loans with high interest rates, this cost can be very significant and can crowd out other, more productive uses of that money
• Indirect costs: Debt constrains your financial options as you have to prioritize making your debt repayment versus other uses of your money. In the case of a mortgage or a car loan, defaulting on the loan will lead to your property or your vehicle being foreclosed and taken away from you. In addition, the more debt you have, the larger the impact on your credit score which will reduce your future financial flexibility

Because of these costs, most financial advisors will recommend that you either don’t get into debt or prioritize paying off your debt as quickly as possible. Now, life is a little more complicated than that as there are times and instances where debt is a “good” — I’ll post an article shortly on what defines a good debt — but in general the recommendation that you minimize debt is a good one.

This completes today’s post on what is debt and why most financial advisors recommend avoiding it. The practical steps you can start taking from today’s post are:

• As part of your budgeting process, keep track of your debt(s): Make sure you know what debts you have and their payment terms
• Determine the priority of servicing and/or repaying each type of debt: Determine which debts are “good” vs. “bad”. I will post an article in the next few days to help you with that determination. Within each of the two categories prioritize which debts(s) you want to pay off first. A simple way of determining this is to choose the highest interest rate debts to pay off first

Thank you again for joining me on my journey to build financial literacy for young adults and their families. If you are interested in reading more of my posts, please access my author page (https://shopping-feedback.today/authors/sudhir-sahay) where you can see all the posts I’ve published. If you have any questions on today’s post of if there are any topics you’re interested in my broaching in future posts, please let me know. I can be reached at [email protected].