Debt 101

Alden Wicker

Debt is a tricky thing. Handled wisely, it can help you reach your dreams. Handled poorly, it will do the opposite. After all, debt can pay for a graduate degree that doubles your salary within five years … or it can lead to unmanageable interest payments and—gulp—bankruptcy.

Yup, the word debt can sound scary. And it’s true–many of us haven’t been using this tool responsibly lately. A U.S. Census Bureau report showed that, in 2009, outstanding credit card debt per cardholder totaled nearly $5,700. Even worse, 1.57 million Americans filed for bankruptcy in 2011.

Despite these harrowing statistics, using debt wisely can be the very definition of living richly. It’s an integral part of buying your own home and for many people, buying a car or becoming qualified for their dream job. Read on to find out what using debt wisely really means.

Debt in a Nutshell

In short, debt is money borrowed from someone with the promise of paying it back at some point, often with interest. That someone could be the bank, credit union, credit card issuer, the government, a furniture store or even your mom, among many other places.

When you take on debt, you get a lump sum of money up front and you pay it back in installments. You also pay the lender interest every month for letting you borrow the money. For example, if you take out a loan for $1,000, and the interest rate is 1% per year, you’ll pay $10 over the course of the year for holding the full amount of the loan.

In most cases, the lender will send you a monthly bill stating how much you are required to pay that month. You have to pay the minimum, but you can choose to pay more in order to pay off the loan faster and save yourself money on interest.

Why You Need to Understand Debt

As of January 2012, average consumer credit card debt stood at over $7,000. Among households that had revolving debt, the average was $15,400. On top of that, student loan debt is on the rise–it jumped 4.6% from 2011 to an average of $35,000.

Despite the fact that credit card debt fell during the Recession (mainly because banks were forgiving bad debts) it’s expected to rise again in 2013, along with defaults. In addition, one in 810 households are still being foreclosed on, and one in six student loan borrowers are in default. Understanding debt can help you avoid these scenarios.

How Debt Works for You …  or Against You

Whether debt is beneficial or deadly is determined by two factors:

  • Interest: This is the money you pay the lender for the privilege of having the money upfront. This interest will compound, which is another way of saying it snowballs. And the higher the interest, the more quickly it will snowball. Interest is the main reason why debt sometimes gets out of control.
  • Whether the debt is taken on as in investment in your future: If you take on the debt in order to leverage, say, greater earnings in the future, then the debt has furthered your financial goals. If the debt won’t yield any future reward, it isn’t an investment but a burden.

But when deciding which debts to pay off first and whether it’s even a good idea to take that type of debt on in the first place, these designations are good rules of thumb:

Good Debt

Good debt usually has a low interest rate–6% or less–and is often seen as an investment in your future happiness and financial stability. These are three common types of good debt:

  • Student loans, which can increase your salary and lifetime earnings, plus improve your quality of life
  • Mortgages, which can help you buy your own home, instead of spending money on rent
  • Business loans, which help you start your own business–which will hopefully lead to higher earnings and a fulfilling career

Not only do these kinds of debt normally offer low interest rates, but the interest may even be tax-deductible! Real estate has the added bonus of sometimes increasing in value.

However, good debt can easily become bad debt if it is taken on without a solid plan for repaying the loan. For instance, if you took out a college loan of $150,000 that lands you a job paying $31,000 out of college, then the debt-payoff ratio is probably dismal enough to make it more like bad debt than good. Also, any debt is bad debt if you aren’t taking responsibility for paying it off.