7.5: Debt

Learning Objectives

1. Explain how debt structures repayment and interest over time.
2. Evaluate the cost and value of different types of debt.
3. Develop a strategy for managing or escaping high-interest debt.
4. Interpret the legal and financial implications of bankruptcy.

Digging In and Climbing Out

What Debt Really Means

Debt is money you’ve already spent, or promised to spend, without yet paying for it. It’s the opposite of savings. Instead of giving your future self a gift, debt hands them a bill.

But debt isn’t always a mistake. It’s a tool, just like credit. And sometimes, it’s the only way forward. Few people can buy a house, pay for college, or cover emergency surgery without borrowing. The danger isn’t in using debt, it’s in using it without understanding what it costs.

Debt always comes with strings. It creates an obligation, adds pressure, and limits flexibility. When used well, it can move your life forward. When misused, it can pin you in place.

How Debt Works (and Grows)

Every debt has three core parts: principal, interest, and term. Together, they shape your repayment. Most debts are paid off in monthly installments, which blend interest and principal.

Early in a loan, the majority of your payment goes to interest. Over time, this shifts, and more of the balance is allocated to the actual balance. This structure, called amortization, is predictable but often misunderstood. The borrower sees a payment going out, but the balance barely moves. That disconnect is built into the system.

Amortization tables show how this works. They list each payment, breaking it down into interest and principal. Understanding this table helps you see where your money is really going and how long you’ll be in repayment.

Miss a payment, and things get worse. Late fees will apply and interest compounds. Your total cost grows. In academic terms, this isn’t just a payment problem; it’s a cost acceleration curve.

Good Debt, Bad Debt, and Real Life

There is a popular idea that some debt is considered “good” (such as student loans or mortgages) and some is considered “bad” (like payday loans or maxed-out credit cards). But real life is more complex.

The true measure of debt is value over time: What you got, what you paid, and whether the payoff justifies the pressure. Debt isn’t just about interest rates; it’s about outcomes.

We evaluate debt not only by its APR, but also by its opportunity cost, or what else those payments could be used for. A 7 percent car loan might be worth it if it helps you get to a job that pays well—but financing a luxury item that depreciates quickly? That’s often just future stress disguised as a lifestyle upgrade.

When Debt Gets Out of Hand

Debt becomes dangerous when it outpaces your income, your planning, or your awareness. The warning signs aren't always dramatic; they're subtle at first. Using credit for essentials, skipping one bill to pay another, and dreading reading your account balances all signal impending financial trouble.

Academic frameworks refer to this as a debt spiral, where interest and fees grow faster than your payments can reduce the balance. Even when you're making progress, it can feel like you're standing still.

The earlier you intervene, the more options you have. Intervention isn't about shame, it's about strategy. That might mean contacting lenders, consolidating balances, or speaking with a nonprofit credit counselor.

The system isn’t designed to call a timeout. You have to press pause yourself.

Climbing Out: Structure Over Shame

Getting out of debt isn’t about guilt or grit, it’s about structure. The right plan creates momentum. The wrong one creates exhaustion.

Start by listing every debt, including the balance, rate, payment, and due date. This gives you a map. From there, you can apply one of two major strategies:

Snowball

Pay off the smallest debt first for quick wins and motivation

Avalanche

Pay off the highest-interest debt first for long-term savings

Neither is “right,” but they solve different problems. One builds a habit. The other saves money. Many students succeed by starting with a snowball strategy and then transitioning to an avalanche strategy as their confidence grows.

While you pay down debt, don’t forget about sinking funds. A sinking fund is a mini-savings account set aside for anticipated expenses. Without them, you risk sliding back into borrowing.

Bankruptcy: Last Resort or Fresh Start?

For some, debt becomes mathematically impossible to repay. Even if you're making monthly payments, interest and fees may grow faster than your ability to reduce the balance. Imagine owing $20,000 with a 24 percent interest rate and only making minimum payments; it would take decades and cost thousands more than you borrowed.

At that point, bankruptcy becomes not just a legal option, but a necessary reset. However, like any reset, it has structure, and that structure matters.

There are two main types of personal bankruptcy in U.S. federal law:

Liquidation

Chapter 7: This process erases most unsecured debts after nonexempt assets are sold. It’s fast, but not everyone qualifies. There’s a means test based on your income.

Reorganization

Chapter 13: You keep your property and repay some or all of your debts through a court-supervised payment plan over 3–5 years. It offers structure for people with steady income who need breathing room.

The key legal term is discharge, a court order that erases qualifying debts and prevents creditors from trying to collect them. Some debts, such as recent taxes, child support, and most student loans, are not eligible for discharge.

Bankruptcy remains on your credit report for 7 to 10 years; however, its impact begins to fade earlier than most people think, especially if you establish good habits for rebuilding your credit. Bankruptcy is serious but survivable. It is not a character flaw. It is a legal tool designed to give people a second chance.

Debt-to-Income Ratio and the Limits of Leverage

In lending, one of the most important indicators is your Debt-to-Income (DTI) Ratio, which is calculated by dividing your total monthly debt payments by your gross monthly income. Lenders use it to determine whether you can afford to take on new debt.

But DTI isn't just for lenders. It’s for you. It's a mirror. If your DTI climbs above 36 percent, your budget is under pressure. Above 50 percent, you're likely robbing one category to cover another. At that point, debt stops being a tool and starts being a cage. When DTI rises, other things shrink, such as your ability to save, seize opportunities, and get a good night's sleep. A high DTI doesn’t just limit your loan options. It limits your life options.

Understand your DTI: How amortization slows your payoff early, how compounding punishes delay, and how opportunity cost shifts the true value of debt. These aren’t advanced theories. They’re survival skills.

Summary

Debt is more than borrowed money. It’s a commitment shaped by:

• structure
• time
• and consequence

This section examines how debt accumulates, accelerates, and how to manage or overcome it. Students learn to recognize early warning signs, evaluate repayment strategies, and understand the legal framework of bankruptcy. With the right tools, debt becomes navigable, and even reversible.

Exercises

1. What role does interest play in your current or past debt decisions? How did you understand it at the time?
2. If you had to restructure your current debt today, what would your strategy be?
3. Calculate your own DTI. What would that number say to a lender, and what does it tell you?