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What is debt? & how does it work?

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    What is debt? & how does it work?

    If you are reading this, you are probably like most people in the developed have debt. Debt can come in all different sizes, from many different areas. In fact, it's pretty hard not to get into debt these days. Debt could be:

    • $100 you owe a friend
    • $1,800 you owe on a credit card
    • $7,400 you owe on your car loan
    • $12,000 you owe on your personal loan
    • $250,000 you owe on your mortgage (or more like $400,000 these days)

    These are just a few of the main examples of debt the average person might have. Every month that you owe somebody money (with the exception of a friend or family in most cases), you have to pay a set amount of that money back to the person (or company) that lent it to you in the first place. This is typically made up of some of the original amount, PLUS what is called interest.

    Interest is the money you are charged for borrowing. It is determined using a percentage of the total amount, often referred to as an Interest Rate. Depending on what you are borrowing for, and who you are borrowing from (the lender), will determine what that interest rate will be.

    As a general rule, the less valuable (or resalable) the item purchased (in the eyes of the lender), the higher the interest rate to borrow money to buy it. "But wait, why is that? That doesn't seem fair." It all comes down to what happens if you can't pay your loan back. The lender will need to recover the money they have lost, and to do that, they will take back what you bought and try to sell it. To understand this better, put yourself in the shoes of the lender.

    If someone wanted to borrow $10,000 off you to go shopping (for clothes, white goods, electronics, etc) or $10,000 off you to buy a car, and if they couldn't pay back the debt, and you had to take the stuff to try and recover your money, which item would you rather be taking back? Now at a personal level, perhaps you may want the first option, but if you are a company, you want to be able to quickly sell the items and get whatever money you can back. Selling a car is much easier than having a garage sale.

    Let's take a quick look at credit cards. This is perhaps the most common form of debt, because it is so easy to get approved for these days. Quite often you will receive credit card applications (sometime pre-approved) in the mail. They can range from a few hundred dollars to well into the six figures. Hard to imagine that some people out there have credit cards with limits (the maximum amount you can use) of more than $100,000, when your card has a limit of only $1,000 or so. "Why is this?" you ask, two primary reasons;

    1. Serviceability, and
    2. Credit History & Credit Rating

    Serviceability is determine by how much you earn and what you likely commitments are. If you have a salary of say $38,000, and your accounts show no other debt commitments, it shouldn't be too hard for you to pick up a credit card for a few thousand dollars. In fact almost anyone can pick up a new card with a limit of $1,000.

    Credit History refers to all the times you've had a previous or current loan and had to make regular payments on it. And Credit Rating refers to how well you made those payments on time. The better your credit rating and serviceability, the better your chances of being approved for larger loans (financing).

    Credit cards typically have the highest interest rates, ranging from as low as 7% or 8%, to as high as 30% or more depending on the economy and the bank or lender. So make sure you shop around and find the one that best suits you. Higher interest rates often come with extra benefits, like purchase insurance, frequent flyer miles, and gifts. However, the extra cost from the higher interest rate may or may not be worth it to you.

    Another form of common debt is a personal loan. These loans typically range from $5,000 to $50,000, and can be used for things like buying a car, a boat, new furniture, making some renovations, starting a business or even taking a holiday. The interest rate would typically be less than or equal to a credit card interest rate from the same institution.

    Perhaps the second most common type of loan is a car loan. When you buy a new car from a dealer (company who sells cars), chances are you wont be paying cash. Dealers will often work with 2 or 3 finance companies that can lend you the money to buy the car from them. The interest rate on these loans is often much better than the personal loans, because it was used to buy [what the bank calls] an asset (something of value).

    And finally the most well known type of loan would be, a home mortgage. This refers to the amount of money you borrow to buy a house. According to the banks, a house is one of the best things you can buy with borrowed money, because historically is holds the most value and doesn't change in value very quickly. Lenders will often lend you between 50% and 95% of the value of the house you are purchasing (provided you can afford to pay for it).

    Out of all the different types of debt we have listed here, a mortgage is definitely one of the best things you buy, because a house will typically goes up in value over time, whereas all the other items go down in value. This is covered more in "The difference between good & bad debt".

    No matter which debt you have; credit card, personal loan, car loan, or home loan, every month you will pay back a pre-determined amount to the lender. Below is an idea of what you might expect to pay back each month.

    • Credit Card: The total amount you owe, multiplied by the interest rate, divided by 12 months and then double it. EG If you have $5000 owing at 12.74% interest rate then your minimum monthly payment will be approx $106 ((5000 x 12.74%) / 12) x 2 ) = $106.16
    • Car Loan: The total amount you owe, multiplied by the number of years for the loan, plus the interest each year, divided by the total number of months. EG If you owe $10,000 @ 10% interest per year, for 5yrs, your monthly payment should be about $458 ((10000 x 5) x 1.10%) / 60mths) = $458.34
    • Home Loan: These are much more complex to figure out, as interests rates are often variable (change with the market), and it is calculated the interest is calculated each month on the new balance. I recommend using a loan repayment calculator to figure this one out. (You can find a calculator for this on my blog)

    Thanks but the info you posted is fairly basic don't you think? Kind of like a lecture on what food is when it's supposed to be a cooking seminar?


      I have to agree with Shewillbemine on this one. Not sure many here are going to gain much from that, but if it was an honest effort to share information...thanks I guess!


        modest debt is a blessing....14 trillion is a national security nightmare