Back

Borrowing money

Lesson in Course: Investing basics (beginner, 5min)

How can I pay for something I need today even though I don't have enough money?

Eureka!

What it's about: Debt is a tool that allows us to buy things today we wouldn't have been able to afford otherwise.

Why it's important: Debt isn't free. Interest is the cost of borrowing money.

Key takeaway: Use debt carefully to buy assets that add to our wealth. Too much debt risks our financial security!

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?

Debt includes the money borrowed, interest, and time of repayment

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.

What is Principal?

The amount that is borrowed

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.

What is Interest rate?

Interest is the additional amount that the borrower pays back to the lender. It is usually expressed as a percent of the principal and is considered the cost of borrowing.

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.

Lower interest rates go to those with better credit scores

 

What is Maturity date?

The decided date in the future when the loan will be paid off.

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.

 
Putting it all together

Let's use the auto loan example from earlier. Instead of $30,000 in cash, we pay $5,000 today and borrow $25,000 from a bank to buy a new car. Let’s also assume we have pretty good credit, and the bank agrees to lend us the money with an interest rate of 5% APR (annual percentage rate) in monthly payments over 5 years.

This means that over 5 years, we'll pay $471.78 each month to the bank to pay back the $25,000 we borrowed plus an additional $3,306.85 of interest. 

In the end, we'll have paid $5,000 down and $28,306.85 for the loan. So we paid a total of $33,306.85 for the $30,000 car. The $3,306.85 interest is the cost of borrowing the money so we could buy the car today.

 

Actionable ideas

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.

Glossary

What is Principal?

The principal of a loan is the amount that is borrowed.

What is Interest rate?

Interest is the additional amount that the borrower pays back to the lender. It is usually expressed as a percent of the principal and is considered the cost of borrowing.

What is Maturity date?

Is the date that something ends or expires.

For options: is the date that the option contract expires. Breaking down options

For a loan: is when the loan will be paid off. It also sets the duration of the debt, how long the borrower will be making payments.