Debt is borrowing money that needs to be paid back in the future, usually with interest. Most of us want or need something that we can't pay for here and now. Going to college or buying a house is too expensive for most of us without the help of borrowing money. However, borrowing more than we can afford to pay back leads to financial problems.
So how does debt work?
The lender and the borrower agree on the terms of a loan, which are the principal, interest rate, and maturity date. Some popular examples we might encounter include student loans, auto loans, mortgages, and credit cards.
If we buy a new $30,000 car and only pay $5,000 upfront as a down payment, the remaining $25,000 is how much we borrow and makes up the principal of our auto loan.
The interest rate reflects compensation to the lender for taking on the risks associated with lending. What if the borrower doesn’t pay the money back? This is where the creditworthiness of the borrower is most important. Lenders offer lower interest rates to borrowers with better credit history. On the other hand, riskier borrowers (those less likely to pay the money back) pay higher interest rates.
The maturity date also sets the duration of the debt, how long the borrower will be making payments. Debt repayment is usually structured with monthly or quarterly payments so that the borrower has more affordable payment sizes and ensures the lender is receiving their money back with interest. A balloon payment is when the borrower makes one large payment at the very end.
Borrowing allows you to buy things now that you might not otherwise be able to afford. This comes at a cost in the form of interest. Remember, debt is a liability that often lowers our net worth.
When used properly, debt is a powerful tool that can provide you with more cash to buy assets that add to your wealth. However, it's also dangerous in large amounts. Taking on too much debt (also known as being highly leveraged) leads to more monthly interest payments than you can realistically afford. This is usually the biggest risk to financial security.