Intro to Debt
Educate yourself on debt before its too late! ⏱ Theres good and bad ways to use debt... continue reading for more info.
In this edition of the Personal Finance Project Newsletter:
🧐 What is Debt?
🔫 Rapid Fire! Listing out the fundamental concepts.
🍕 Some food for thought… general understandings of debt.
What is Debt?
Lets start with a couple of definitions of debt:
A state of being under obligation to pay or repay someone or something in return for something received.
(Mariam-Webster Dictionary)
Something, usually money, borrowed by one party from another.
(Investopedia)
Debt is a fundamental aspect of personal finance. Though this edition does not include any updates to the Financial Tracker and Budget Table, stay tuned for future updates to reflect the tracking and budgeting of debt. 📢
You will notice that this edition takes on a more direct, bullet-point form because we need to cover some relevant terms and concepts. The terms and concepts will not be exhaustive, but will include the information that I believe is most relevant to us who are being introduced to debt. The information I am providing you will add the concept of debt to your financial repertoire so that you can seek out debt or further debt education with a general understanding of the elements involved.
Of course, future editions on debt will elaborate on the topics covered today. 🔮
Key Lingo
Let’s cover some key debt lingo. Consider this list to be one you can freely reference back to as you read through more content in the future. The order is arranged for progressional understanding.
Debtor - The party receiving debt. 🤲
Creditor - The party issuing debt, likely a bank or financial institution. 🏦
Principal - The amount of money being loaned and thus (eventually) repaid.
Interest - The amount, in addition to the principal, to be repaid to the creditor. Consider interest as the cost of borrowing, i.e. the cost of debt. Interest is expressed as an interest rate, which is (usually) an annual percentage that is (usually) charged monthly. It is charged on the renaming balance of the principal.
Down Payment - Some debts (like car loans and mortgages) require the debtor to pay a minimum amount upfront before they can access the funds.👇 The idea is that the debtor provides partial payment for the purchase, and with that, they now have access to a loan which is used to finance the rest of the purchase. The principal does not include the downpayment, strictly the loaned amount.
Grace Period - The time between the initial undertaking of the debt and the beginning of obligatory repayments. Student loans, 👨🎓 for example, typically demand the loan repayment begin once the student has finished their studies (though the specific terms vary depending on the creditor).
Collateral - An asset pledged by the debtor to ensure the repayment of the debt. Essentially, this asset is used as insurance in the case that the debtor defaults (fails to repay) on the debt. The creditor has a claim to the collateralized asset in an attempt to earn back the money that was not repaid.
Secured versus Unsecured Debt - A secured debt is one where collateral must be pledged, and unsecured debt requires no collateral. 🔐
Revolving Debt - Refers to the debtor's access to the debt. With revolving debt, the debtor is provided a predetermined borrowing limit that allows more flexibility regarding when funds can be borrowed and repaid. Think of a credit card, 💳 where the debtor has a credit limit under which they can borrow and repay according to the current outstanding balance.
Loan 🆚 Line of Credit - The difference between a loan and a line of credit is the revolving nature of a line of credit. With a loan, the debtor is provided the total loan amount based on their need (such as purchasing a car). This means the principal balance outstanding is the amount loaned. With a line of credit, the debtor is provided access to the total amount of a preset borrowing limit. Only the funds withdrawn from the line of credit are considered as the outstanding principal (to which interest charges are applied).
Maturity Date - The date by which the debt must be fully repaid. 📆
Credit Score - A numerical value representing your creditworthiness (suitability to receive credit). Creditors use credit scores, among other factors like current employment income, requested loan amount, current debt levels, etc. to determine if they will approve the debt application. In short, on-time repayments means the credit score rises, and defaults or high credit balance means the credit score falls.
Characteristics of Different Types of Debt
This table summarizes some characteristics of the most common types of debt. Though not accurate for every single case, use this for basic differentiation.
Strategy and Philosophy
The following is what I believe to be some general understandings of debt.
Only go into debt that you can afford to repay. 😵
Shop around. Just like shopping for the best price for your new shoes, 👟 shopping for the best interest rate can significantly decrease the amount of interest you pay.
When you can pay more than your minimum payment, do it! 👏 When you do, it goes toward your principal, which decreases your interest payments in future periods.
Good Debt and Bad Debt
Surprise! Not all debt is bad. 🤯 Have you ever heard of good debt compared to bad debt?
In reality, all of us will take on debt. Debt may be the only means of affording some of life’s most expensive commitments, such as buying a house, growing a business, or going to school.
Good debt is debt used to buy an asset that increases in value or leads the debtor to a better financial state where paying off the debt is affordable. 👍 Of course, unpredictable future events may cause the debtor to default on any debt, but debt that generates higher future income at low risk is generally considered good debt. In short, good debt is debt that will benefit your future, like mortgages, student loans, and business loans.
On the other hand, bad debt is debt used to purchase unproductive assets with no long-term benefit. 👎 When thinking about bad debt it helps to consider the purchase itself. Ask yourself, "Is this purchase worth the extra interest charges? Will this purchase make me financially better off?". If your answer to either question is no, you likely shouldn't purchase with debt. Credit cards and payday loans are examples of bad debt instruments due to their high-interest, however paying for irresponsible consumption with debt of any kind is financially irresponsible.
Final Words
The best way to take responsibility when securing debt is to read the contract. Seriously… don’t simply sign at the bottom. Take your time (in the bank or even take the document home) and read the terms. Ask the banker when you don’t understand something, or bring someone who is knowledgable on banking.
Here are the most important questions I seek answers to: 👀
What is the interest rate?
When is the maturity date?
When will I have to make payments?
How much are my monthly payments?
Can I pay off my debt early?
You are the sole person in control of your money - nobody can force a financial decision on you (including the decision to take on debt). Whether you’re buying a car, getting a bank loan, or even buying a new phone, don’t sign any contract if you are feeling under pressure to do so.
That's a Wrap.
I should've apologized in advance for the length of this one! I'm learning as I go here, and in the future I promise to take a more engaging approach to such a complex (and perhaps dry?) topic such as debt.
⏰ What's to come in future newsletters:
Debt and the Financial Tools.
How Credit Cards Work.
Explaining Interest Rates.
✅ What we've covered today:
Debt Defined.
The (non-exhaustive) Debt Glossary.
Thinking About Debt in a Practical Way.