loans and debt

Loans: What type of debt do you need to know about?

What are loans? What is debt? And what do you need to know about it before taking out loans or opening a line of credit? Simply put, s loan is an arrangement (typically with a bank) that allows you to borrow money now and pay it back later. Sounds pretty sweet, right? This can allow you to buy things you don’t have the money for in the present, like a car or college tuition. Until you pay back the borrowed money,  you are in debt. There are consequences to being in debt, and finance professionals like Dave Ramsey strongly advise against it. You can read more about his view on debt here.

 Dave Ramsey mentions that the topic of debt is an extremely important topic to get a grasp of because 77% of Americans are in debt (Ramsey, 2021). The more surprising fact is that a lot of this debt is credit card debt. This means a lot of the money that people borrow is not for a car or college tuition! So should you go into debt for things you want/need? This blog will provide you with the information necessary to make this decision.

Types of debt/loans

There are many different types of debt, and it’s important to know what they are because they’re not all the same. The main types of debt are credit card debt, student loans, car loans, and mortgage loans. Credit card debt is money spent with a credit card that isn’t paid back to the bank after an agreed upon grace period. With credit cards, banks typically give you a month to pay back what you borrowed. The money borrowed during this month is your statement balance. You can use your credit card as you would use a debit card, and pay your statement balance at the end of the month.

Student loans is money borrowed from a bank used for college/university. A lot of the debt in the US comes from student loans, and that’s because a lot of people can’t afford college tuition.

Taking out car loans means you’re borrowing money to buy a vehicle. This is where your car payments come from.

Lastly, there is mortgage loans. Mortgage loans is money borrowed to buy a house. Most of the debt in the US comes from mortgage loans. This is because houses are expensive, and their prices are increasing in the long run. We’ll talk about why that is in another blog post. In all, the cumulative debt in America is in the trillions of dollars.

So what is the downside of being in debt? Is there any downside on spending money you don’t have and won’t be able to pay in the future?

Consequences of loans

The price to pay for borrowing money is called interest (expressed as a percentage of money borrowed). Interest means that every pay period you don’t pay off your debt, you owe an extra amount of money.

Heres an example:

I borrow $1,000 from Timmy. Timmy says I can pay him back next month. But, if I don’t pay him back in exactly one month, I owe him 3% of my borrowed money for every month I’m late (this is called interest). 

A month goes by, and I don’t have $1,000 to pay him back, but I have $400. I give him the $400, so the remaining balance I owe him is now $600 ($1,000 original money I owed – $400 I already repaid Timmy). But, I also owe him 3% of the remaining borrowed money I’m late on. 3% of $600 is $18.00. So I don’t actually owe $600, I owe $600 + $18.00 = $618. 

Another month goes by and I’m unable to pay the $618 I owe Timmy. I only have $400 again. Timmy says “no problem, give me the $400, next month you owe me your remaining balance ($618- $400=$218), plus an extra 3%. So I now owe $218, plus 3% of $218 which is $6.54. So I owe $218 + $6.54 which is $224.50.

Next month comes, and I have the $224.50 to pay Timmy. I pay him, and I am now officially done paying him for the money I borrowed. I’m happy, because I was able to get an advance on the $1000 I needed, and it only took me 3 months to pay Timmy back. So who got screwed in this deal?

Lets reflect: Timmy gave me $1,000 two months ago, and over the course of those two months I gave him $224.50+$400+$400 = $1,024.50. So for borrowing money, I lost $24.50 ($1,024.50 – $1,000) to Timmy. 

This seems like a small amount of change. But consider this 3% interest applied to something as big as student loans or mortgage for a house. Interest here can add up to tens of thousands dollars! Also, it’s worth noting that credit card debt has interest rates of up to 25% interest. If this was applied to the situation with Timmy, instead of only losing $24.50, I would lose $175 for borrowing money! 

Loans: summary

So should you go in debt and take out personal credit? There is no right answer. You have to make the trade off for yourself. Ask yourself the question: is the thing I am going into debt for worth it? Sometimes, the answer is yes (sometimes)! For example, going into student loan debt to go to med school. In this case it may be worth it because you will make a lot of money as a doctor. I would think of my student loans as an investment in my future, since I don’t have the money now to get this degree, but I will in the future. 

But, if you are debating if it’s worth going into credit card debt, the answer is typically no. This is because you are not investing into your future when using a credit card. I would recommend paying your credit card bill on time at the end of every month to avoid interest payments. Worth noting, for other forms of debt, like student loans mortgage, the interest begins once you take the loan (there is no grace period like with credit cards).

The topic of credit and debt is complex, and there are a lot of conflicting expert opinions out there. I try being as unbiased as possible when talking about debt because it comes down to individual preference and lifestyle. Everyone is different, and I understand that.

In the next blog, I talk about something called a credit score, which is a reward system for borrowing money. There are advantages and disadvantages to a credit score, and there are many ways to improve and also ruin your credit score. Make sure to follow along for the next blog if you are ready for a more complex discussion around credit and debt!


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