Debt
Debt is a tool. Used wisely, it accelerates wealth-building. Used poorly, it's a trap that compounds against you. Understanding the difference is essential.
Good Debt vs. Bad Debt
Not all debt is equal. The distinction comes down to whether the debt builds wealth or destroys it.
| Type | Examples | Typical Rate | Why |
|---|---|---|---|
| Good debt | Mortgage, student loans (reasonable), business loans | 3-7% | Builds equity, increases earning power, generates income |
| Neutral debt | Auto loans (reasonable car), 0% financing | 0-7% | Necessary but doesn't build wealth |
| Bad debt | Credit cards, payday loans, personal loans for consumption | 15-400% | Funds depreciating assets or consumption |
The test: Does this debt help me earn more or build equity? If no, it's bad debt.
When Debt Makes Sense
- Mortgage at 4-7% on an affordable home (builds equity, tax-deductible)
- Student loans for a degree with strong earning potential (compare ROI by field)
- Business loan with a solid business plan and revenue model
- 0% financing when you have the cash (invest the cash instead)
When Debt Is Dangerous
- Any credit card balance carried month-to-month
- Financing vacations, clothing, or electronics
- Payday loans (effective APR often 400%+)
- Borrowing to invest (margin trading, crypto loans)
- Co-signing for unreliable people
How Interest Works
Simple Interest
Interest calculated only on the principal.
Simple Interest = Principal × Rate × Time
$10,000 at 5% for 3 years:
$10,000 × 0.05 × 3 = $1,500 total interest
Used for: Some auto loans, some personal loans.
Compound Interest
Interest calculated on principal plus accumulated interest. This is what most debt uses, and it's what makes debt dangerous.
Compound Interest = Principal × (1 + Rate/n)^(n×t) - Principal
$10,000 at 20% compounded monthly for 3 years:
$10,000 × (1 + 0.20/12)^(12×3) - $10,000 = $8,114 total interest
The Real Cost of Minimum Payments
Credit card minimum payments are designed to keep you in debt.
| Balance | APR | Minimum Payment | Time to Pay Off | Total Paid |
|---|---|---|---|---|
| $5,000 | 20% | 2% ($100 min) | 9+ years | $10,000+ |
| $5,000 | 20% | $150/month | 3.5 years | $6,300 |
| $5,000 | 20% | $250/month | 2 years | $5,500 |
| $10,000 | 24% | 2% ($200 min) | 20+ years | $24,000+ |
| $10,000 | 24% | $400/month | 2.8 years | $13,400 |
Minimum payments are a trap. Even small increases in payment dramatically reduce time and total cost.
APR vs. APY
| Term | Meaning | Used For |
|---|---|---|
| APR (Annual Percentage Rate) | Stated annual rate, may not include compounding | Loans, credit cards |
| APY (Annual Percentage Yield) | Actual return accounting for compounding | Savings accounts |
A 20% APR credit card compounded monthly has an effective annual rate of 21.9%.
Debt Payoff Strategies
Avalanche Method (Mathematically Optimal)
Pay minimums on everything. Throw all extra money at the highest-interest debt first.
Example debts:
| Debt | Balance | Rate | Minimum |
|---|---|---|---|
| Credit Card A | $3,000 | 24% | $60 |
| Credit Card B | $5,000 | 18% | $100 |
| Car Loan | $12,000 | 5% | $250 |
| Student Loan | $20,000 | 4.5% | $220 |
Avalanche order: Card A → Card B → Car → Student Loan
Extra $300/month goes to Card A first. When Card A is paid off, $360/month ($300 + $60 minimum) rolls to Card B.
Pros: Saves the most money. Mathematically optimal. Cons: If the highest-rate debt is also the largest, it takes a long time to see progress.
Snowball Method (Psychologically Optimal)
Pay minimums on everything. Throw all extra money at the smallest balance first.
Snowball order: Card A ($3,000) → Card B ($5,000) → Car ($12,000) → Student Loan ($20,000)
Pros: Quick wins build momentum. You see debts disappearing. Cons: Costs more in interest than avalanche.
Which to Choose
| Factor | Avalanche | Snowball |
|---|---|---|
| Total interest paid | Lower | Higher |
| Time to debt-free | Shorter | Longer |
| Psychological wins | Slower | Faster |
| Completion rate | Lower | Higher |
| Best for | Math-motivated people | People needing motivation |
Research says: More people actually complete the snowball method because the psychological wins keep them going. Choose the one you'll stick with.
Hybrid Approach
- Pay off any debt under $500 first (quick wins)
- Switch to avalanche for everything else
- If you stall, switch back to snowball for a win
Debt Consolidation
When It Makes Sense
- You can get a significantly lower interest rate
- You'll stop accumulating new debt
- The consolidation fees don't eat the savings
- It simplifies multiple payments into one
Options
| Method | Typical Rate | Best For |
|---|---|---|
| Balance transfer card | 0% for 12-21 months | Credit card debt under $10,000 |
| Personal loan | 6-15% | Multiple debts, decent credit |
| Home equity loan | 4-8% | Large debt, own a home (risky, your home is collateral) |
| 401k loan | Prime + 1% | Last resort only (opportunity cost is enormous) |
| Debt management plan | Negotiated | Working with nonprofit credit counseling |
Balance Transfer Cards
| Factor | Details |
|---|---|
| Intro rate | 0% for 12-21 months |
| Transfer fee | 3-5% of balance |
| Post-intro rate | 18-25% |
| Credit needed | Good to excellent (700+) |
Math check: 3% transfer fee on $5,000 = $150. If you'd pay $900 in interest otherwise, the transfer saves $750. Worth it if, and only if, you pay it off before the intro period ends.
When Consolidation Is a Trap
- You consolidate but keep spending on credit cards
- The new loan has a longer term (lower payment but more total interest)
- You use home equity (turning unsecured debt into secured debt)
- You pay fees that exceed the interest savings
Credit Scores and Reports
What's a Credit Score
A three-digit number (300-850) that predicts how likely you are to repay debt.
| Range | Rating | Typical Impact |
|---|---|---|
| 800-850 | Exceptional | Best rates on everything |
| 740-799 | Very good | Excellent rates |
| 670-739 | Good | Average rates |
| 580-669 | Fair | Higher rates, may need deposits |
| 300-579 | Poor | Denied or very high rates |
For detailed credit score information, see 06-credit.md.
How Credit Score Affects Debt Cost
| Credit Score | Mortgage Rate (approx.) | Monthly Payment on $300,000 | Total Interest Over 30 Years |
|---|---|---|---|
| 760+ | 6.5% | $1,896 | $382,600 |
| 700-759 | 6.9% | $1,975 | $410,900 |
| 660-699 | 7.3% | $2,055 | $439,800 |
| 620-659 | 7.9% | $2,178 | $484,200 |
A 100-point credit score difference can cost over $100,000 on a mortgage.
Student Loans
Federal vs. Private
| Feature | Federal | Private |
|---|---|---|
| Interest rates | Fixed, set by Congress | Fixed or variable, credit-based |
| Income-driven repayment | Available | Not available |
| Forgiveness programs | PSLF, IDR forgiveness | None |
| Deferment/forbearance | Generous | Limited |
| Bankruptcy discharge | Very difficult | Very difficult |
Repayment Strategies
| Strategy | Best For |
|---|---|
| Standard (10-year) | Fastest payoff, lowest total cost |
| Income-driven (SAVE, PAYE, IBR) | Low income relative to debt |
| Refinancing | Strong income, good credit, high-rate loans |
| PSLF (Public Service Loan Forgiveness) | Government/nonprofit workers with federal loans |
Key rule: Never refinance federal loans into private loans unless you're certain you won't need federal protections (income-driven repayment, forbearance, forgiveness).
Is the Degree Worth the Debt?
| Field | Median Salary | Typical Debt | Debt-to-Income | Verdict |
|---|---|---|---|---|
| Engineering | $85,000 | $35,000 | 0.4x | Strong ROI |
| Computer Science | $90,000 | $30,000 | 0.3x | Strong ROI |
| Nursing | $80,000 | $40,000 | 0.5x | Good ROI |
| Business | $65,000 | $40,000 | 0.6x | Moderate ROI |
| Education | $50,000 | $35,000 | 0.7x | Consider PSLF |
| Art/Music | $40,000 | $50,000 | 1.3x | Risky |
| Law | $85,000* | $160,000 | 1.9x | Depends on school/market |
*Median is misleading: law has a bimodal salary distribution.
Rule of thumb: Don't borrow more than your expected first-year salary.
Mortgage vs. Renting
The Real Math
Buying isn't always better. Compare total costs:
Buying costs people forget:
- Closing costs (2-5% of purchase price)
- Property taxes (1-2% of home value annually)
- Home insurance ($1,000-3,000/year)
- Maintenance (1-2% of home value annually)
- HOA fees ($200-500/month in some areas)
- Opportunity cost of down payment
- Transaction costs when selling (6-8% of sale price)
The 5% Rule (rough guide): Multiply home value by 5% and divide by 12. If you can rent for less than that number, renting may be cheaper.
$400,000 home × 5% = $20,000/year ÷ 12 = $1,667/month
If rent < $1,667, renting may be better financially.
This accounts for property tax (~1%), maintenance (~1%), and cost of capital (~3%).
When Renting Wins
- You'll move within 5 years
- Local rent is cheap relative to home prices
- You'd need to stretch beyond 28% of income for housing
- The housing market is overvalued
- You value flexibility and mobility
When Buying Wins
- You'll stay 7+ years
- Monthly payment (PITI) is comparable to rent
- You have 20% down payment saved
- Stable income and employment
- You want to build equity and lock in housing costs
Debt Traps to Avoid
| Trap | Why It's Dangerous |
|---|---|
| Payday loans | 400%+ APR, creates debt cycles |
| Rent-to-own | Pay 2-3x retail price |
| Buy-here-pay-here dealers | 20-30% interest on depreciating cars |
| Store credit cards | 25-30% APR, opened for a 10% discount |
| Cash advances | 25%+ APR, fees, no grace period |
| Title loans | Lose your car if you can't pay |
| Borrowing from retirement | Penalties + lost compound growth |
| Cosigning | You're 100% liable when they don't pay |
Getting Out of Debt: Action Plan
Step 1: Stop the Bleeding
- Cut up credit cards (or freeze them in ice)
- Cancel unused subscriptions
- Switch to cash/debit for discretionary spending
- Stop financing anything new
Step 2: Know What You Owe
List every debt:
| Debt | Balance | Rate | Minimum | Payoff Order |
|---|---|---|---|---|
Step 3: Find Extra Money
| Source | Potential Monthly |
|---|---|
| Cut subscriptions | $50-200 |
| Reduce dining out | $100-300 |
| Sell unused items | $200-500 (one-time) |
| Side income | $200-1,000 |
| Negotiate bills | $50-150 |
| Tax withholding adjustment | $50-200 |
Step 4: Execute
- Pay minimums on all debts
- Apply all extra to target debt (avalanche or snowball)
- When one debt is paid, roll that payment to the next
- Celebrate each payoff (free celebration, no spending)
- Don't take on new debt during payoff
Step 5: Stay Debt-Free
- Build emergency fund immediately after debt payoff
- Use credit cards only for what you'd buy anyway (pay in full monthly)
- Wait 48 hours before any purchase over $100
- Remember how debt felt
Key Takeaways
- High-interest debt is an emergency. Treat it like one
- Minimum payments are designed to keep you in debt. Pay more
- Pick avalanche or snowball and commit. Both work
- Consolidation only works if you stop accumulating. Fix the behavior
- Not all debt is bad. A reasonable mortgage is fine
- Student loans need a strategy. Don't just default to standard repayment
- Run the numbers on rent vs. buy. The answer isn't obvious
- Credit score directly affects debt cost. Protect it