Too many people take on debt but don't understand how it works.
Let me teach you the basics of how debt can help you OR prevent you from reaching your financial goals:
Let me teach you the basics of how debt can help you OR prevent you from reaching your financial goals:
Debt is something (typically money) that's owed to someone else.
When you take on debt, you're borrowing consumption from your future.
When you take on debt, you're borrowing consumption from your future.
Bringing consumption to the present has a cost. When you borrow money, you are taking away consumption from someone else.
Lenders earn interest when they lend money - you are getting access to their current consumption.
Lenders earn interest when they lend money - you are getting access to their current consumption.
Here's how interest works:
Interest is the cost of borrowing money and is charged annually as a percentage of the amount you borrow.
If you borrow $100 at a 10% interest rate, your interest cost would be $10/year.
Interest is the cost of borrowing money and is charged annually as a percentage of the amount you borrow.
If you borrow $100 at a 10% interest rate, your interest cost would be $10/year.
This amount you owe may compound (grow) over time.
Compounding leads to exponential growth: your debt will grow faster over time. Compound interest is interest charged on interest.
Compounding leads to exponential growth: your debt will grow faster over time. Compound interest is interest charged on interest.
Let's say you leave your $100 debt unpaid at the end of year 1 and have a balance of $110
During year 2, you'll be charged interest on the amount borrowed AND the interest you owe. End of year 2: You owe $121 ($110 + 10%).
End of year 3: you owe $133.10 ($121 + 10%).
During year 2, you'll be charged interest on the amount borrowed AND the interest you owe. End of year 2: You owe $121 ($110 + 10%).
End of year 3: you owe $133.10 ($121 + 10%).
Common forms of debt:
Mortgages - money borrowed using real estate as collateral. Low interest rates because of the low risk to the lender (they can sell the real estate to get their money back if the borrower defaults).
Credit cards - allow you to conveniently borrow money, but at very high interest rates. Credit cards have a grace period during which you don't pay interest on the money you borrowed (usually ~21 days). Credit cards don't require collateral - they are backed by the trust that you will pay back your debts.
Lines of credit - similar to credit cards, but with no grace period. Interest rates are usually lower (could be less than half). Some lines of credit can require collateral (for example, a Home Equity Line of Credit), and charge lower interest rates.
Mortgages - money borrowed using real estate as collateral. Low interest rates because of the low risk to the lender (they can sell the real estate to get their money back if the borrower defaults).
Credit cards - allow you to conveniently borrow money, but at very high interest rates. Credit cards have a grace period during which you don't pay interest on the money you borrowed (usually ~21 days). Credit cards don't require collateral - they are backed by the trust that you will pay back your debts.
Lines of credit - similar to credit cards, but with no grace period. Interest rates are usually lower (could be less than half). Some lines of credit can require collateral (for example, a Home Equity Line of Credit), and charge lower interest rates.
Debt is a tool that will magnify the results of your decisions.
You can use it to buy whatever you want.
The difference between "good debt" and "bad debt" isn't the interest rate, but how the debt fits into your overall financial plan.
You can use it to buy whatever you want.
The difference between "good debt" and "bad debt" isn't the interest rate, but how the debt fits into your overall financial plan.
If you use debt to buy something that will be consumed, you may be left owing money for something you no longer own.
On the other hand, if you use debt to buy an asset, you can continue to own the asset and generate cash flow or capital gains even after the debt is paid off.
On the other hand, if you use debt to buy an asset, you can continue to own the asset and generate cash flow or capital gains even after the debt is paid off.
Student loans can be good OR bad:
1) You can borrow to get a degree that gives you new career options and/or a bump in pay
2) You can borrow to get a degree that has no value to the economy and doesn't lead to an increase in income
1) You can borrow to get a degree that gives you new career options and/or a bump in pay
2) You can borrow to get a degree that has no value to the economy and doesn't lead to an increase in income
Debt magnifies the result of your decisions through leverage:
You are using borrowed money to make a decision with the expectation that profits you earn will be greater than the interest you pay to borrow the money.
You are using borrowed money to make a decision with the expectation that profits you earn will be greater than the interest you pay to borrow the money.
Credit card debt is almost always seen as bad debt but it can give you opportunities that you may otherwise never have.
For example, you can use debt to save time. Using a credit card to finance the purchase of a car may seem like you're taking on bad debt, but that purchase might save you 3 hours of commuting every day.
You can use this time to improve your lifestyle and create an asset, like a business, that pays you forever.
For example, you can use debt to save time. Using a credit card to finance the purchase of a car may seem like you're taking on bad debt, but that purchase might save you 3 hours of commuting every day.
You can use this time to improve your lifestyle and create an asset, like a business, that pays you forever.
You can ALSO go deep into credit card debt to pay for consumption, like entertainment.
This entertainment may marginally improve your life in the moment, but over the long term, it could hurt you if you can't pay off the debt right away.
This entertainment may marginally improve your life in the moment, but over the long term, it could hurt you if you can't pay off the debt right away.
A general rule of thumb:
Pay off debt with an interest rate higher than 6-8% as soon as possible.
Generally, its difficult to earn a higher return than 6-8% (of course there are some exceptions, like career growth).
Why?
Pay off debt with an interest rate higher than 6-8% as soon as possible.
Generally, its difficult to earn a higher return than 6-8% (of course there are some exceptions, like career growth).
Why?
Let's say you borrow money to invest at 8% and you can buy an investment with an expected 10% return.
On the surface level, you are earning 2% on your investment BUT:
- You are taking on risk, which is the possibility of something bad happening (what if your investment goes to 0?)
- Investment returns are never guaranteed and can fluctuate over time - your investment may not be profitable for years while you pay interest
- If your investment loses value, the lender may ask you to pay back the debt immediately
Since gains and losses are magnified by debt, you may lose MORE than you have the potential to gain.
On the surface level, you are earning 2% on your investment BUT:
- You are taking on risk, which is the possibility of something bad happening (what if your investment goes to 0?)
- Investment returns are never guaranteed and can fluctuate over time - your investment may not be profitable for years while you pay interest
- If your investment loses value, the lender may ask you to pay back the debt immediately
Since gains and losses are magnified by debt, you may lose MORE than you have the potential to gain.
You can purchase a $500,000 house without borrowing money.
An INCREASE of 20% in the value of the house would mean your equity (value of ownership) in the house increased by 20%. A 20% DECREASE means you lose 20%.
An INCREASE of 20% in the value of the house would mean your equity (value of ownership) in the house increased by 20%. A 20% DECREASE means you lose 20%.
On the other hand, if you borrow 80% of the value of the house, you pay $100,000 in cash and borrow $400,000. The $100,000 is "equity" (ownership) and the $400,000 is debt.
If the value of the house drops 20% (this is definitely possible) to $400,000, all of your equity in the house would be wiped out (you STILL owe $400,000).
On the other hand, if the value if the house increases 20% to $600,000, your equity would increase by 100% to $200,000 ($600,000-$400,000).
If the value of the house drops 20% (this is definitely possible) to $400,000, all of your equity in the house would be wiped out (you STILL owe $400,000).
On the other hand, if the value if the house increases 20% to $600,000, your equity would increase by 100% to $200,000 ($600,000-$400,000).
In conclusion:
Just like every other personal finance concept or tool, debt is not always good or bad.
If you take on debt for the right reasons, you could end up in a significantly better position over the long term.
If you take on debt without a plan, you could end up in a terrible situation that's difficult to get out of.
Just like every other personal finance concept or tool, debt is not always good or bad.
If you take on debt for the right reasons, you could end up in a significantly better position over the long term.
If you take on debt without a plan, you could end up in a terrible situation that's difficult to get out of.
I'm passionate about helping more people become financially literate, but these threads take a long time to write.
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If you found value in this post, make sure you like and retweet the first tweet, and subscribe to my FREE NEWSLETTER (the link is in my bio).
Thanks for reading!
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