Credit and Debt
Explain credit scores, loans, interest, credit cards, debt repayment, and the risks of high-cost borrowing.
A lesson of Economics, in Personal Finance, about 10 minutes.
Credit and Debt Management
By the end of this lesson, you will be able to explain how credit works, calculate interest costs, compare debt repayment strategies, and make informed borrowing decisions.
How Credit Works
Credit: the ability to borrow money with a promise to repay it in the future (usually with interest).
Lender's perspective: they are taking risk that you won't repay → they charge interest as compensation for that risk and for the time value of money.
APR (Annual Percentage Rate): the cost of borrowing expressed as a yearly percentage, including fees. Higher APR = more expensive debt.
Credit score (FICO 300–850): reflects your creditworthiness. Higher score → lower APR → cheaper to borrow.
Types of Credit
Revolving credit (credit cards):
- Spend up to your limit, pay back each month
- No interest if you pay the full balance monthly
- Very high interest (18–29% APR) on carried balances
Installment loans (mortgage, car loan, student loan):
- Fixed monthly payments over a set term
- Lower APR than credit cards
- Secured (collateral — house, car) or unsecured (student loans)
Lines of credit: similar to revolving credit; flexible borrowing up to a limit.
The Cost of Carrying a Balance
Example: $5,000 balance at 24% APR, making minimum payments (2% of balance):
- Minimum payment starts at $100/month and declines
- It takes over 30 years to pay off
- Total interest paid: $8,000+ — more than the original balance
Pay more than the minimum. The minimum payment is designed to maximize interest revenue for the lender.
Debt Repayment Strategies
Debt avalanche (mathematically optimal):
- Pay minimums on all debts
- Direct extra payments toward the HIGHEST INTEREST RATE debt first
- Minimizes total interest paid
Debt snowball (psychologically effective):
- Pay minimums on all debts
- Direct extra payments toward the SMALLEST BALANCE first
- More motivating; costs slightly more in interest
Which to use: the avalanche saves more money; the snowball keeps more people on track. Use whichever you'll actually stick with.