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Economics & Personal Finance
Loans and Debt
Loans and Debt
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Loans let people, businesses, and governments buy things now and pay for them over time. They matter because borrowing can make education, homes, cars, and business investment possible, but it also creates a legal obligation to repay. The total cost of a loan depends on the amount borrowed, the interest rate, fees, and how long repayment takes. Understanding debt helps students make better financial decisions and compare borrowing options.
Key Facts
- Principal is the original amount borrowed before interest and fees.
- Simple interest formula: I = P r t, where P is principal, r is annual interest rate, and t is time in years.
- Total repayment with simple interest: A = P + I.
- For installment loans, each payment usually covers interest first and then reduces principal.
- Longer loan terms usually lower monthly payments but increase total interest paid.
- Debt burden can be measured with debt-to-income ratio: DTI = monthly debt payments / gross monthly income.
Vocabulary
- Principal
- The amount of money originally borrowed or still owed on a loan before adding future interest.
- Interest
- The cost of borrowing money, usually expressed as a percentage of the principal.
- Annual Percentage Rate
- The yearly cost of a loan including interest and some fees, expressed as a percentage.
- Collateral
- Property pledged by a borrower that a lender can take if the loan is not repaid.
- Default
- Failure to repay a loan according to the agreed terms.
Common Mistakes to Avoid
- Confusing principal with total repayment is wrong because the total amount paid includes interest and possibly fees, not just the original loan.
- Choosing the lowest monthly payment without checking total cost is wrong because a longer term can make the loan much more expensive overall.
- Ignoring the difference between interest rate and APR is wrong because APR can reveal added borrowing costs such as fees.
- Assuming all debt is bad is wrong because some borrowing can support valuable investments, but only when repayment is affordable and the terms are understood.
Practice Questions
- 1 A student borrows $2,000 at 6% simple annual interest for 3 years. How much interest will the student pay, and what is the total repayment amount?
- 2 A borrower has gross monthly income of 1,000. Calculate the debt-to-income ratio as a percentage.
- 3 Two loans have the same principal and interest rate. Loan A has a 3-year term and Loan B has a 6-year term. Explain which loan is likely to have the higher total interest cost and why.