Debt: What is it, and how can it hurt (or help) you? with our fictional friend Alice

Spending more than you make means you need to pay someone else more than you’re being paid. This requires that you take on debt to cover the difference, or that you deplete your savings, effectively creating debt that Current You owes Future You, which you’ll have to make up for at some point. Debt (to a bank, credit union, or similar institution) is expensive because you don’t just pay back the difference between how much money you have and how much you need—the amount you borrowed, is called the principal. You also pay whoever lent you the money a fee for having done so: interest, which is calculated as a percentage of how much remains to be paid on the principal.

Let’s illustrate this with an example: Alice makes $120,000 a year, so $10,000. If our fictional Alice lives in the state of Georgia, then she’ll owe federal and state income tax on her $120,000. Let’s assume that one month when she doesn’t have any savings to draw from, Alice makes a particularly bad financial decision to spend $8,000 shopping, on top of her regular expenses. Alice gets her taxes withheld—she doesn’t see the money, ever, because her employer takes it out of her paycheck before depositing it—and makes a $1600 contribution to her retirement. (She won’t see that money for many years, depending on how old she is.) Considering her tax liability and her contributions to her retirement, Alice takes home $6,124 a month. 

During a normal month, Alice has perfectly allocated every cent she makes to one of several budgeting categories. But she spent $8,000 more on her credit-card-funded shopping spree than she was prepared to pay. Soon, there will come a bill from the credit card requiring Alice to pay back the $8,000. She put the $8,000 on her credit card which charges her interest if she doesn’t pay the balance in full. During normal months, she doesn’t accrue interest because her income exactly covers paying off her statement as we assumed earlier. But this month, she can only pay what she normally pays, and she can’t pay anything toward the shopping spree. Her credit card charges her interest, in the amount of 25%. This means that every year, she gets charged 25% of what remains on her balance, extra, by the credit card company, as the cost of having lent her the money to do the shopping spree, with the understanding that she’d pay for it when the statement came due.

Let’s say Alice reevaluates her budgeting priorities and spends a little bit less each month on her essentials, and completely cuts out going out with her friends so that she’ll have an extra $400 to use toward her debt. Remember, she needs to pay back the $8,000 cost of the shopping spree, plus the 30% interest, and she’s doing that at $400 a month. Let’s assume that she, at least, always pays on time, so we don’t have to account for late fees or any other fees, and that she always pays $400. Paying $400 a month toward her debt of $8,000 actually takes 28 months, during which she’ll have paid a total of $11,228 on a shopping spree that, at the register, cost $8,000 because of the fact that she must also pay off the interest. Of that $400 monthly payment she had to make every month for more than 2 years, about $95 was interest.

The point of this section is not, as some popular speakers have done, to argue against all debt. Some debts can be good: they’ll allow you to go to school, or to buy a house. But Alice’s case is different and isn’t a mortgage or student loan. Let’s look at the difference those kinds of debts would make. Of course, Alice could get a better job with more education, so the degree she got with those $8,000 would pay for itself over time because she’d earn more money than she would have without the degree, and $8,000 toward a house (not that such a house exists) would help her build equity. But what I want to draw your attention to here is the interest rates. 

Student loans through the federal government—loans through other private entities have much higher rates, making them even more difficult to pay off—for undergraduates average about 3 to 6% APR. If Alice had had her $8,000 debt at that rate (let’s split the difference and say those loans average 4.5%) put toward her education, instead of the 25% from the credit card put toward the shopping spree, she would have saved almost $2,900 in interest and, as mentioned before, she would have significantly increased how much she could have earned in the future. Ultimately, taking on the debt to go to school, and paying $400 a month for that would have made her life better, but the same can’t be said about the debt she put toward looking fashionable for her friends. 

Let me end this explanation with an important caveat. Not all debt is inherently bad, to be perfectly clear. Mortgages you can afford, for instance, are good, because they give you a place to live, and help you build equity in a house, probably the most expensive asset you'll ever own. But high-interest debt taken out by holding a balance on a credit card can be financially crippling because of how much extra the person in debt will be required to interest (and possibly fees).