What is debt?
Key takeaways
04 · ideas- Debt is borrowed money you must repay with interest — a real financial cost
- Good debt builds wealth (mortgage, education); bad debt depletes it (credit cards)
- At 20% APR, $6,000 in credit card debt costs $1,200/year in interest alone
- Debt-to-income ratio above 43% makes it hard to qualify for major loans
Basic level
The essentials · 1 min
Debt is money you owe. When you borrow money, you create a debt — a legal obligation to repay the principal plus interest.
Not all debt is the same. Financial experts often distinguish:
"Good" debt — borrowing that can build wealth or increase earnings:- Mortgage: builds equity, historically appreciates
- Student loans: can increase lifetime earnings
- Business loan: can generate profit exceeding the cost
- Credit cards at 18–29% APR
- Payday loans at 300%+ APR
- Car loans for vehicles that depreciate immediately
- Buy-now-pay-later with high deferred interest
Average credit card debt: $6,000 at 20% APR
- Annual interest: $1,200
- At minimum payments: takes 17+ years to pay off, costs $8,000+ in interest
- Total cost: $14,000+ on $6,000 borrowed
Intermediate level
How it applies · 2 min
Types of debt and their true costs
| Debt type | Typical APR | Secured? | Can build wealth? | Priority to pay off |
|---|---|---|---|---|
| Federal student loans | 5–8% | No | Sometimes | Medium |
| Mortgage | 6–8% | Yes | Often | Low |
| Auto loan | 6–12% | Yes | No | Medium |
| Personal loan | 10–25% | No | No | High |
| Credit cards | 18–29% | No | No | Highest |
| Payday loans | 300–400% | No | No | Immediate emergency |
The minimum payment trap
Credit cards are designed to keep you in debt as long as possible:
$6,000 credit card balance at 22% APR:
| Payment strategy | Monthly payment | Time to pay off | Total interest |
|---|---|---|---|
| Minimum only (2%) | ~$120 → decreases | 23 years | $8,400 |
| Fixed $150/mo | $150 | 8.5 years | $4,300 |
| Fixed $250/mo | $250 | 3.5 years | $1,800 |
| Fixed $500/mo | $500 | 14 months | $740 |
Paying 4× the minimum ($500 vs $120) cuts payoff time from 23 years to 14 months and saves $7,660 in interest.
Debt-to-income ratio
Lenders calculate your DTI to assess whether you can handle more debt:
| DTI | Assessment | Mortgage eligibility |
|---|---|---|
| < 28% | Excellent | Easy approval |
| 28–36% | Good | Standard approval |
| 36–43% | Acceptable | Possible with compensating factors |
| > 43% | Risky | Hard to qualify |
| > 50% | Danger zone | Generally denied |
Example: $800 car + $400 student loan + $200 credit card = $1,400/month debt on $5,000/month income = 28% DTI.
Advanced level
The math, step by step · 1 min
The mathematics of debt payoff optimization
Avalanche method (mathematically optimal):
Pay minimums on all debts, put every extra dollar to the highest-APR debt first.
Where T_i^{min} is payoff time at minimums and T_i^{opt} is payoff time with optimized payments.
Debt consolidation math:Consolidating $20,000 at 24% average APR to 12% personal loan:
- Original monthly interest: $400
- Consolidated monthly interest: $200
- Monthly savings: $200
- Annual savings: $2,400
- 3-year total savings: $7,200
But consider: Consolidation only helps if you don't accumulate new debt on freed-up credit lines. Behavioral economics research shows ~50% of people who consolidate credit cards accumulate new balances within 2 years, ending up with more total debt.
Debt and net worth
Debt (liabilities) directly reduces net worth. But low-interest debt used to acquire appreciating assets can increase net worth — this is leverage. A $60,000 down payment on a $300,000 home (borrowing $240,000) can produce higher net worth growth than paying rent with the same $60,000, if home values appreciate faster than the mortgage interest cost.