Debt
Debt is created when you borrow money. Debts can be person to person but they are more typically between you and a bank. The bank can loan you money by giving you cash, giving you a line of credit, or giving you a credit card. (Using a credit card is borrowing money from the bank, using a debit card is taking cash directly from your checking or savings account.)
Whenever a bank or individual loans you money, there is interest. Interest is the amount of money the lender charges for you to borrow what you need. This amount is a percentage of your total loan amount. The percentage is stated as a yearly figure, and it applies to every dollar you borrow for however long you owe the money.
So if you borrow $20,000 at 5% interest for one year, you owe $1000 of interest for the year in addition to the principal amount you borrowed originally, and so to pay off this debt you must pay $21,000. If you borrow the money for five years before you begin to pay it back, then you owe $5000 in interest on top of the $20,000 principal you borrowed and so you must pay $25,000 to clear the debt.
If you borrow $20,000 at 10% interest, you would owe $22,000 the first year and $30,000 in five years. Interest adds up quickly as you see. The higher your interest rate, the faster it adds up. Only borrow money if you have to and always at the lowest rate you can get.
Credit cards charge a very high interest rate and should only be used in emergencies. With only a very few exceptions, if you don’t have the cash to make a purchase then don’t make it. Borrowing money using a credit card might be very convenient but it is one of the worst financial strategies you can employ.
If you have to use a credit card for something such as an online purchase, always pay the entire balance every month as soon as you get the bill. That will keep your interest payment as low as possible and in some cases might eliminate it altogether since many banks allow you to make purchases interest-free and only begin to charge you interest on the unpaid amount you still owe after your payment is due. So if you owe nothing after the due date, having paid the entire balance due, you will be charged no interest. There is nothing wrong with using a credit card this way.
When you have a larger balance than you can pay in cash, the lender will typically arrange for a monthly payment plan. This plan will require you to pay a certain amount every month for a long period of time in order to pay off the debt. Included in that monthly payment would be some principal and some interest. So only a portion of your monthly payment actually goes to paying down your debt amount, the rest goes to the interest fee. The more principal you owe, the larger the amount interest you owe every year and thus every month.
As a quick example, suppose you had a monthly payment plan for a $20,000 debt at 10% that requires you to pay $500 per month. 10% of $20,000 is $2000. Divided by 12, that’s $166 per month. That leaves $334 to pay down your principal amount. But if you only owe $10,000, your monthly interest is only $83 per month and you have $417 left over to pay down your actual debt.
As show above, interest accumulates quickly over time and can become a huge part of paying off a debt if it is not done so quickly. Whether by credit card or otherwise, only borrow in emergencies. Live within your means, and if you want things you can’t get yet then let them inspire you to a bigger and better life.
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Debt
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