Most people living in North America have some form of debt. That can include anything from credit cards, student loans, a car loan, a mortgage, or a payday loan. Given how common debt is, you would think people would talk about it more. But topics such as how much we owe, what interest rate we pay, and what are our repayment strategies are taboo.
Why is the subject of debt off-topic when the majority of us have it? That is one area of
finance people find especially challenging to face, let alone to discuss in detail. But that's
what we're tackling in this blog post: debt.
In order to understand debt, you have to understand what credit is. Credit is the ability to purchase something before you actually pay for it. It is a loan someone gives to you
based on trust that you will pay it back in the future. Credit allows us to purchase items
we couldn’t ordinarily buy because we don’t have enough cash on-hand.
Credit can be very convenient, allowing us to satisfy our needs and wants without having
to first save money. Credit allows us to get something now that we think we can afford in
the future. In this way, credit can help us out of a jam, like when you have an unexpected
big expense and you still need to buy groceries. It allows us to eventually purchase
homes, as nearly no one could ever save enough to buy a home in cash. Credit can spread out your purchasing ability over your lifetime, such as needed when attending school. If you expect a college education to raise your lifetime earning power, but you will only see that increase well after you had to pay for the education, then it can make sense to borrow.
That said, credit also allows us to make impulsive purchases for items we can’t afford, like buying an expensive car or vacation.
Such convenience is not free. You still have to pay for the items you bought, and then
you have to pay the lender additional money through interest charges and fees. This is the incentive the lender has to loan you money and to take on the risk that you won’t pay
back the loan.
Interest is charged as a percentage rate of the total amount you owe. Let’s pretend you
want to buy a new $1000 couch and you pay using your credit card. Your credit card’s
interest rate is 18% APR (Annual Percentage Rate), so if you don’t make any payments
after one year you will owe $1000 + $180. After two years, you will owe an additional
$212.40. You are paying not only interest on the original amount you borrowed, but also
interest on your previously accrued interest. This is called compound interest, and it is
one of the reasons that having too much debt can spiral out of control.
Fees can be more complicated than interest. Some loans incur significant up-front fees
such as origination fees and closing costs for a mortgage. Credit cards and lines of credit
can have annual fees regardless of whether you use them or not, and charge very large
fees if you are late making a payment.
Other loans, such as payday loans, don’t charge interest at all but force you to pay back the loan every two weeks, and if you can’t they charge a lot to open a new loan to pay back the old one. In each of these cases, you are paying for both the access to borrow money and for not having paid it back in total.
Going back to the example of the couch, if the credit card company has a minimum
monthly payment of $40, but charges 0% interest (unlikely!), it will take 25 months to
pay back the money you borrowed. But since 18% interest is charged, and interest is
charged on any previously accrued interest, you will need to pay $1263, and it will take
you an extra seven months to pay it back!
This is where compound interest comes into the picture, and where we tie credit back to
debt. If someone loans you money based on your ability to pay it back, but you are
unable to pay what you owe immediately, you are in debt. As discussed before, this in
itself is not bad, as long as you have calculated the costs, have good reason to borrow the money, and can easily pay it back over time. But with the process of compound
interest, which people often miscalculate, it can feel like your financial train to success comes off the rails. More on that in Part Two of our posts on debt, where we discuss how to get out of debt.
If you're in debt and would like help coming up with a plan to get out of it, please contact us for an appointment.
Squirrel and Nest offers one-on-one and small group financial counseling services that aim to give individuals the knowledge and independence they need to get their financial lives in great shape.