Detailed Explanation
Debt is a financial obligation where you borrow money with an agreement to repay it, usually with interest, over a specified period. While debt often has negative connotations, it can be a useful financial tool when managed strategically.
Types of Debt
Secured Debt: Loans backed by collateral that the lender can claim if you default-mortgages, auto loans, home equity loans.
Unsecured Debt: Loans not backed by collateral, typically carrying higher interest rates-credit cards, personal loans, medical debt.
Revolving Debt: Credit that can be used repeatedly up to a limit-credit cards and lines of credit.
Installment Debt: Loans repaid in fixed amounts over a set period-mortgages, auto loans, student loans.
Good Debt vs. Bad Debt
Good debt finances appreciating assets or increases earning potential: mortgages on property, education loans, business investments.
Bad debt finances depreciating items or consumption: credit card balances, payday loans, financing luxury items.
Debt Payoff Strategies
Avalanche Method: Pay minimums on all debts, put extra money toward highest interest rate first. This approach minimizes total interest paid.
Snowball Method: Pay minimums on all debts, put extra money toward smallest balance first. Psychologically motivating-quick wins build momentum.
Examples
Debt Inventory Example
| Debt | Balance | Rate | Minimum | Payoff Order (Avalanche) |
|---|---|---|---|---|
| Credit card | $8,000 | 22% | $160 | 1st |
| Personal loan | $12,000 | 11% | $350 | 2nd |
| Auto loan | $18,000 | 6% | $380 | 3rd |
| Student loan | $35,000 | 5% | $350 | 4th |
| Mortgage | $250,000 | 6.5% | $1,580 | 5th |
Interest Cost Example
$10,000 credit card at 20% APR:
- Minimum payments only: 25+ years to payoff, $12,000+ in interest
- $400/month payments: 2.5 years to payoff, $2,800 in interest
Why It Matters
Understanding debt can be relevant to various financial considerations:
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Interest Drain: High-interest debt compounds against you, eroding wealth over time.
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Cash Flow Freedom: Eliminating debt payments frees money for saving and investing.
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Stress Reduction: Debt creates financial anxiety; paying it off provides peace of mind.
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Financial Independence: Some consider reducing debt an important factor in progress toward financial independence.
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Opportunity Unlocked: Without debt payments, you have flexibility for career changes, risks, and opportunities.
Tracking all debts-balances, rates, minimums-in a spreadsheet can provide visibility into your overall debt picture.