What is debt and is it all bad?
Dec 13, 2023
There may be some stigma when it comes to debt, but it’s a part of everyday life. Debt is actually one of the building blocks of society as we know it. Banks, corporations, modern couples, even countries use it. And the very idea of money, written language, and trade all formed around the concept of debt.
It was also created to speed things up. After all, debt enables us to do something before we’ve saved up for the full amount it costs. Just think about all of the long trade voyages that took place in the renaissance. Many of those treks wouldn’t have happened without first taking on debt, to then return with a haul and more to pay it all back.
Debt has been in use for centuries
So we know debt is not a new concept. People have been using debt even long before our great grandparents. It just looked a bit differently.
Flash back many centuries ago to ancient Sumeria. An olive tree farmer’s crops got hit by a drought, and he was left in trouble the rest of the year with no harvest to trade. To tide him over until the next season, the olive tree farmer asked his neighbor, a goat farmer, to lend him some surplus goats he could use for trade.
The following year, the rains returned and produced a plentiful olive crop. The olive tree farmer returned the same number of goats to his neighbor plus a few bottles of olive oil for the trouble. Even though this was the olive tree farmer’s way to survive hard times, the exchange is debt at its core.
In some ways, not much has changed since then. Society still relies on borrowing, lending, and trading to protect and build wealth and make economic transactions happen. The options available for debt, however, have become increasingly complex over the years.
At Plenty, we're here to break it all down for you in a simple, easy to understand way. In this article we'll cover:
What is debt, exactly?
When can debt become a problem?
How can Plenty help?
What is debt, exactly?
Debt is an amount of money that you borrow from a lender (usually a bank or credit card company). Like the ancient Sumerian olive farmer, you (the borrower) agree to repay an institution or person (the lender) the borrowed amount along with interest within a specified period of time.
The average American carries a whopping debt balance of $101,915. If that number seems high, think of all the ways a person can accumulate debt.
Carrying a balance on your credit card? Debt. Still paying back your student loans? Debt. Mortgages and car loans? Also debt.
What is “good” debt versus “bad” debt?
Debt isn't inherently good or bad. It can be a powerful tool that sets you up for financial success in the long run. However, some forms of debt are better than others.
Let's look at a few examples of what might be considered "good” debt.
Student loans help pay for an education that can connect you to career opportunities and higher earning potential.
Mortgages empower people to buy their own homes, which can provide stability and build equity as the home (potentially) increases in value over time.
Small business loans can help people launch businesses that generate income and provide great personal fulfillment.
Sometimes, though, even "good debt" can pile up and make it harder to achieve financial security. And to make things even trickier, consumers have to navigate around a growing number of predatory lenders whose goal is to lure people in with deceptive marketing tactics.
Here are some examples of what can fall into the “bad” debt category - debt with high interest rates that’s used for things that do not grow in value faster than the interest rate.
Payday loans have short repayment periods and are notorious for very high interest rates and costly fees.
High-interest credit card balances can become super expensive over time for consumers who only pay their accounts’ minimum balance due each month.
Personal loans for nonessential purchases such as luxury vacations can become an expensive habit.
When can debt become a problem?
When you take out a loan, it comes with an interest rate. One of the main reasons lenders charge interest is to earn a profit on the money they're loaning to you - they are in business to make money after all.
But from a consumer perspective, paying interest can add up really quickly especially when you're dealing with large sums of money. And when a loan has a particularly high interest rate, the longer it takes you to pay it off, the more you’ll pay in the long run, which can quickly trap you into just barely keeping up.
In fact, JD Power reports that 51% of American credit cardholders carry revolving debt. This means these consumers are unable or unwilling to pay off their credit card balances in full each month. To add on top of that, roughly 40% of cardholders don’t know what interest rate they’re getting charged (CNBC, 2023). All of this coupled with a lack of understanding of how credit card math works is troubling.
Think about the basics. When interest rates are high, it’s much better to be a saver or a lender than a borrower. When interest rates are low, it’s cheaper to borrow money. However, be careful about giving into the temptation to buy things you truly don’t need. Loan simulators can help you compare various outcomes when you’re deciding which path to take.
Let's look at an example of student loan debt.
Marina is excited to be the first person in her family to go to college. She's been accepted to a great school, and she's confident that after graduation there will be lots of career opportunities. She just needs $10,000 a year in student loans to cover the difference between her savings and the scholarship the college has offered her.
She finds a student loan provider willing to lend her $40,000 (for four years of college) with a 10 year plan to pay it back. She's thrilled until she reads the fine print and sees that the interest rate is 10%. Using a student loan simulator, she determines that after graduation she'll owe the lender $529 per month for a decade, and ultimately pay over $23,000 in interest on a $40,000 loan – a total over $63,000.
Luckily, Marina figures this out before signing the paperwork. After doing more research, she finds another lender with a 6% interest rate. After graduation, she'll pay a much more reasonable $444 per month, and pay back a total of $53,000 on the $40,000 loan, with only $13,000 in interest. Phew.
Things to watch out for before taking on debt
The best way to stay out of bad debt is to avoid it in the first place. Here are some red flags to watch out for when you're considering any kind of loan, whether it's a new credit card, student loan, or mortgage.
High interest rates: Predatory loans often come with extremely high interest rates that are much higher than what's considered reasonable. As a general rule of thumb, anything with an interest rate over 10% should have you looking very closely at the terms.
Unnecessary fees: Although nobody likes to read fine print, it’s there to help protect consumers. Predatory lenders are known for burying hidden fees in the fine print that borrowers are unaware of upfront. These can be tricky to spot, so read the fine print closely and look for terms like "processing fees" or "origination fees." Also check for penalties on early repayment - these can occur if a lender charges a borrower fees for paying off some or all of their loan early. And note any fees that weren't discussed upfront or included in the advertised interest rate.
Pressuring sales tactics: Predatory lenders may use high-pressure sales tactics to convince borrowers to take out loans they don't need or can't afford. If you’re feeling pushed or rushed, take a step back.
Personal loans you don't need: It's one thing to take out a mortgage to buy a home or a small business loan to open up that bookshop. But you should try not to lean on personal loans or credit cards to pay for things you can’t afford and do not need. It’s far better to save up for those first than pile on debt that can slow down your progress toward bigger financial goals.
Payday loans. These are one of the most predatory loans around. Payday loans take advantage of people who need cash quickly by piling on interest rates and repayment terms that are nearly impossible for anyone to keep up with. If you find yourself in a tough spot and need access to cash quickly, try a local credit union or bank instead. You're much more likely to get a fair interest rate with reasonable repayment terms.
How can Plenty help with debt management?
At Plenty, we like the avalanche method, one of two schools of thought on paying off debt. The avalanche method focuses on paying off debts with the highest interest rates first. This way, you end up paying the least amount of debt over time.
The second approach to paying off debt is known as the snowball method. It focuses on paying off debts with the smallest balances first to help you gain momentum. Quick wins help keep us motivated.
Here's an example of the avalanche method in action.
Let's say you have $200 extra to put toward debt payoff each month and three loans outstanding:
A $10,000 loan balance with a 15% interest rate and a $225 minimum monthly payment.
A $5,000 loan balance with an 8% interest rate and an $85 minimum monthly payment.
A $1,000 loan balance with a 4% interest rate and a $20 minimum monthly payment.
If you used the snowball method, you would pay off the $1,000 loan first, then the $5,000 loan, and lastly the $10,000 loan. You'd be out of debt in 38 months and pay a total of $19,621.
However, if you used the avalanche method, you would pay off the $10,000 loan, then the $5,000 loan, and lastly the $1,000 loan. You'd pay back your debt in 36 months and pay a total of $18,854.
Not only does the avalanche method help you get debt free two months faster than with the snowball method in this scenario, but you would also save $767 in interest payments.
Keep in mind this is just a hypothetical example and your own numbers will be different. But it illustrates our point: while it might feel better to get that sense of satisfaction of paying off the smallest loan quickly, aka snowball method, you can save time and money conquering high interest loans first with the avalanche method.
Either Debt Pay Off Method Is Great
Whether you use the avalanche method or the snowball method to pay off debt, the important point is that you’re taking action.
At Plenty, we want you to get out of debt faster and pay less in the long-term. Whichever route you choose, our tools make it easy to visualize your progress as you go.
Open an account with Plenty today and see how we can help you find the right balance between paying off your loans and building wealth for the future.
– Team Plenty
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