How Debt Works

Understanding how to think about and manage your debts is key for financial security.

Debt requires monthly payments, and that reduces your cash flow. Some debts carry additional risks. For example, if you lose your job and don’t pay your car loan, you will be taking a bus to your job interviews after your car is repossessed. Maybe you urgently need a car and buy one from a shady “buy here, pay here” dealer that saddles you with an 18% interest loan and you owe more than the car is worth. Let’s avoid these situations.

Bad Debt

  1. Credit card debt. Other than some rare exceptions, this is bad debt.
  2. Car loans are often bad debt. There are ways to minimize how bad they are and they do serve our transportation needs, but all things equal, most people probably are better off without a car loan.
  3. Loans for furniture, electronics, or other store credit is generally bad.

“Good debt”

So-called good debt could be

  1. A reasonable student loan that prepared you for a high-income career.
  2. Your mortgage which allows you to (somewhat) lock in a fixed housing expense (taxes and insurance tend to go up..).
  3. A line of credit that gives you liquidity for emergencies.
  4. A mortgage on a rental property that boosts your returns.

I say could be good because it really depends on the terms of the loan.

The good news is that whether you have good debt or bad debt or a mix, the methods to get it under control are similar.

Some debts may need to be paid off as soon as possible while others may just need to be periodically checked to see if you can improve the terms with a refinance.

Credit card debt

Let’s start with the worst of the worst. Credit cards typically charge 16-25% or more on balances more than a month old. There are some years where the stock market earns that kind of return, but those are rare. Put another way, you will get a better investment return by getting out of credit card debt than you can expect to earn through investing. You need to get out of credit card debt first.

  1. Stop using your card immediately. In the fine print of most credit cards, any payments you make to the card will pay off the lowest interest debt balance on the card first. In other words, your payment will be applied to your most recent charges that aren’t accumulating interest first. If you use the card to buy $100 of groceries and make a $100 payment, it will pay down the most recent $100 purchase, not the old balance that is accruing interest.
  2. Be sure to make at least the minimum payments to avoid additional fees. If you miss a minimum payment, your interest rate will likely increase to a default rate, which is often around 30%. This is very bad.
  3. Review how much you owe and your interest rate.
  4. If your rate is already “low” (for a credit card) such as in the 8% range, you may want to just pay it down aggressively.
  5. If your rate is higher, consider a balance transfer, but be extremely careful here. Read my article about balance transfers first. Done correctly, they can be a powerful tool, but it is very easy to do them incorrectly and find yourself getting deeper into debt. Balance transfers often have very deceptive advertising – don’t just get a “0% APR” balance transfer card.
  6. Consider a personal loan from a local credit union, LendingClub or Prosper to pay off your credit card debts and get a lower fixed rate loan.
  7. If you take these steps above you will be on the path to get out of credit card debt.
  8. I have no experience with bankruptcy. If your debt is impossible to escape, you may need to talk to a bankruptcy attorney.

Car loans

Car loans are often bad debt. When you bought your car, did you talk to the sales guy about what payment you wanted? Was the negotiation about payment instead of price? You may have been swindled.

Fret not, though. This can usually be corrected by refinancing your car loan with a reputable lender. Even if you weren’t taken advantage of, it may still be beneficial to refinance depending on current interest rates and what you owe.

When the discussion is about payment instead of price, you will probably be steered towards the most expensive or inflated price cars that can be bought for that payment and poor loan terms. In other words, you end up overpaying for a car and paying higher interest than you should. See my car buying guide.

The fix

You can’t go back in time but you may be able to fix your loan. Get your most recent statement and look at your outstanding balance and interest rate.

Check a site like for an idea of current auto loan rates. Your actual rate will be different based on your personal situation, but it’s good to know the benchmark figures. Is your rate higher?

If so, look up local credit unions to find a rate. Some big banks actually also have good auto refinance rates, but some of the craziest low rates tend to be from a local credit union.


When you make a payment on a loan, a portion of that payment goes to interest and a portion goes to paying down your balance. I like to use this Amortization Calculator because it lets you fill in the details you know and will calculate what you leave off (if you entered enough details to solve for the missing). For example, if you know your interest rate, remaining balance, and payment, it can calculate how many payments you have remaining.

Enter these values in the calculator so our results match. Be sure to check the box “Show Amortization Schedule”.


Click Calculate and you should see these results for a $30,000 loan with 72 months of payments and a 5% interest rate:


Scroll down and you’ll see the amortization table which shows you a line by line breakdown of each payment and how much of each payment is going to interest and principal. It also shows your:

  • Cumulative Principal (Cum Prin) – How much of your balance you will have paid off
  • Cumulative Interest (Cum Int) – How much interest you will have paid so far
  • Principal Balance (Prin Bal) – How much you will still owe after that payment

Use this to enter each of your loans and see how much interest you are paying and get a clear understanding of how your debts work.

Refinance your debt

Everyone should consider doing this. Even if you got high-quality loans from competitive lenders originally, interest rates today may be lower today. Refinancing a few loans could give you hundreds of dollars per month cash flow, reduce your total interest paid, and get you out of debt faster.

  1. Gather the latest statements for all of your debts.
  2. Note the interest rate, outstanding balance, and required payment.
  3. Look up current interest rates at a site like for the type of loan you want to refinance.
  4. Use an Amortization Calculator to calculate what your new payment would be at a lower interest rate or different term.
  5. Compare the interest you will pay if you do nothing vs the interest you will pay after refinancing.
  6. Search for reputable lenders to refinance your loans.
  7. Do a check up like this at least once a year to be sure you aren’t paying more than you need.


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