Archimedes Finance

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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?

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 can also lead to financial problems.

So how does debt work?

The lender and the borrower agree on the terms of a loan. These terms are the principal, interest rate, and maturity date. Some popular examples we might encounter include student loans, auto loans, mortgages, and credit cards.

Principal

The principal of a loan is the amount that is borrowed. For example, if we are buying a new car that is $30,000 and pay $5,000 as a down payment, the remaining $25,000 is what we are borrowing and makes up the principal of our auto loan.

Interest Rate

Interest  is the additional amount that the borrower pays 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. The more creditworthiness the borrower, the lower the interest rate offered and the riskier the borrow is, the higher the interest is asked.

Maturity Date

The maturity date  is 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 lender 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

Using the auto loan example, let’s say we borrow that $25,000 from a bank to buy a new car. Let’s also assume that we have pretty good credit and the bank agrees to lend us the $25,000 with an interest rate of 5% APR in monthly payments over 5 years.

This means that over a 5-year period, we will pay $471.78 each month to the bank to pay back the $25,000 we borrowed plus an additional $3,306.85 of interest. 

After all of this is done, we paid $5,000 down and $28,306.85 on the loan, totaling $33,306.85 for the car. The $3,306.85 interest is the price we paid in order to borrow the money to buy the car today.

Borrowing allows us to pay for things now that you might not otherwise be able to afford. This comes at a cost in the form of interest. Taking on too much debt, also known as being highly leveraged, can lead to interest payments that are more than we can pay each month. Be sure to check out our lesson on comparing the cost of debt to see how changing the terms of the loan impacts the interest.

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.

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