Debt and Interest

Introduction

Debt is borrowed money you repay, usually with interest, the price of borrowing. Used carefully, borrowing can help, for example for education or a home. Used carelessly, interest can grow faster than you can repay.

Key terms

• Principal: the amount you borrowed.
• Interest rate: the percentage charged for borrowing, usually per year.
• APR (annual percentage rate): in many countries, a standardised yearly cost of credit that includes some fees. It is useful for comparing offers, but check how your country defines it.
• Term: how long you have to repay.
• Minimum payment: the smallest amount you must pay. Paying only the minimum on a credit card can keep you in debt for years.

How interest grows debt

Example (simple monthly interest): you owe 1,000 on a card at 24 percent a year, which is about 2 percent a month. After a month, interest is about 20, so you owe 1,020 before payments. If you pay only 25, the balance falls just 5. Most of your payment goes to interest. Paying more than the minimum shortens the debt and reduces the total interest.

Another example, a loan: 10,000 over 36 months at 6 percent a year has a monthly payment of about 304.22. Total paid is about 10,951.90, so interest is about 951.90. A longer term lowers the monthly payment but raises total interest.

Good debt and bad debt?

The labels are not perfect. Think about:

• Purpose: does it build something useful, such as education, a necessary vehicle or a home, or fund consumption?
• Cost: how high is the interest and are there fees?
• Affordability: can you repay it even if your income drops?
• Alternatives: can you wait, save or pay in part?

Paying debt down

Two common strategies, once you make minimum payments on all debts:

1. Avalanche: put extra money on the debt with the highest interest rate first. It usually minimises total interest.
2. Snowball: put extra money on the smallest balance first. It may cost slightly more interest, but quick wins motivate many people.

Choose the one you will stick with. Also:

• Stop adding new debt where you can.
• Ask lenders about lower rates or hardship options.
• Consider consolidating only if the new total cost is lower, and read the fees.
• Keep a small emergency fund so surprises do not push you back into debt.

Predatory lending

Be careful with:

• Payday and very short-term loans with extremely high effective rates.
• Lenders who ask for fees upfront before approving a loan.
• Pressure to sign quickly or unclear terms.
• Loans that need your car title or valuables as security, where losing them is likely.
• Buy now pay later schemes if they encourage overspending or hide fees.

Read the terms. If you cannot understand the total cost, do not sign. If you are struggling, use free, independent debt advice services, not paid intermediaries who promise to make debts vanish.

Try it yourself

List every debt with balance, interest rate and minimum payment. Decide avalanche or snowball, and work out how much extra you could pay each month.

Summary

• Interest is the price of borrowing, and high rates make small payments barely reduce the balance.
• Compare cost, purpose and affordability before borrowing, and choose a repayment strategy you will keep.
• Avoid predatory loans, and use free, independent advice when struggling.