Debt: When It Helps, When It Compounds, and How to Clear It

Debt is money borrowed now and repaid later, with a charge for the time in between. Debt helps when the thing bought outlasts the borrowing and the charge is smaller than the alternative. Debt hurts when the charge outruns what can be paid. Clearing it is arithmetic rather than willpower, and the amount paid above the minimum decides most of the answer.

One fact about debt gets left out more often than any other. The household described here paid what it was asked to pay, in full and on the due date, in every single month, and the amount it owed rose in every single month. Nothing was skipped. Nobody stopped trying. The balance went up anyway, and the reason is arithmetic rather than character.

Underneath every question in this subject sits one comparison. Strip away the products and the names and the paperwork, and a debt is a race between two speeds: the speed at which the amount owed grows, and the speed at which a household can push it down. Every other question here is one of those two speeds wearing different clothes. Once both are written as numbers instead of felt as pressure, the whole subject turns into arithmetic that can be done on the back of a bill.

A borrowing carries a charge, a two part test that decides whether it helps, a balance that can rise in a month when every payment was made, a spiral with three ingredients, two standard orderings for clearing several debts at once, and one change worth more than all the others put together.

What is debt, and what is the charge actually paying for?

Think about a vegetable seller who takes stock from a wholesaler in the morning and pays for it at the end of the day. She has the vegetables before she has the money. For twelve hours she is holding something that is not yet paid for, and the wholesaler is going without money he could otherwise have used. The twelve hours are the whole of it. Debt is having the use of something now and settling later, and the charge is the price of the hours in between.

The charge on a borrowing is rent on time, not a penalty and not a fee for being short of money. Somebody handed over money they could have used elsewhere, and they are being paid for the interval before it comes back. Priced by how long, exactly like rent on a room, the charge is quoted as a rate per period rather than as a lump. Borrow more and the rent is larger; borrow for longer and the rent is larger; and if the amount owed is bigger next month than it was this month, the rent is charged on the bigger number.

Everything later depends on keeping two words apart, so both are worth pinning down now. The principalThe amount actually borrowed, before any charge is added to it. When a payment is split, the part that reduces the principal is the part that shrinks what is owed. is what was borrowed. The charge is what is paid for the time. A payment can go to either, and the split between the two is the single most useful thing to know about any payment a household makes. Two households can pay the same amount every month for a year, and one of them can finish the year owing less while the other finishes owing more, purely because of how each payment split.

There is a third word underneath both. CompoundingCharge being worked out on an amount that already includes charge added earlier, so the base the charge is applied to keeps growing. is what happens when the charge is added to the amount owed and next month's charge is worked out on the new, larger figure. Nothing sinister is going on. The rent is simply charged on everything currently owed, and the charge added last month is now part of what is owed.

What are the two speeds that every debt question comes down to?

Here is the whole subject in one picture. Each month, two things happen to the amount owed. Something pushes it up: the charge for the month, plus anything new that has been borrowed. Something pushes it down: the payment made. Whether the debt is getting better or worse is simply which of the two is bigger. The comparison between those two amounts is not a simplification of the subject. The comparison is the subject.

Take the Bhosale household's card in October of the year followed here. The balance stood at Rs 17,480/- at the start of the month. The charge for the month came to Rs 612/-. Groceries and fuel of Rs 6,000/- went on the card because the money was not there in the account. So Rs 6,612/- was added. Against that, Rs 1,205/- was paid, the full amount the card asked for. Rs 6,612/- going on and Rs 1,205/- coming off means the amount owed rose by Rs 5,407/- in a month in which nothing was missed, and the balance moved from Rs 17,480/- to Rs 22,887/- exactly as those numbers say it must.

One of the two speeds is far easier to change than the other. The speed it grows is set by a contract somebody else wrote and by whatever the household is still having to put on the card. The speed it comes down is set by one number: what gets paid. The asymmetry between the two speeds decides where effort is worth spending, and it is worth carrying through everything that follows.

When does borrowing help a household, and when does it hurt?

No general verdict exists, and anybody handing one down is guessing about a house they have never been inside. A test with two parts settles the question instead, and anybody can apply the test in about a minute.

The first part asks whether the thing bought outlasts the borrowing. A sewing machine bought on twenty four instalments is still sewing in the fourth year. A roof repair holds through several monsoons. A vehicle that gets somebody to work is still doing it long after the last instalment. In each case the household is paying, month after month, for something it is still getting the use of. Now put a week of vegetables against the same test. The vegetables are eaten by Sunday and the borrowing runs on. Where the thing is gone and the borrowing is not, every remaining payment buys nothing at all, and that gap separates borrowing that works from borrowing that only postpones.

The second part asks whether the charge is smaller than the alternative. Households skip the second part, and it cuts both ways. The alternative might have been three years of fares, or a job that could not be reached at all, so somebody who borrows Rs 82,000/- for a vehicle and pays Rs 12,500/- in charges over thirty months has not automatically made a mistake. Equally, a charge that looks small each month can be enormous once it is added up over the months it will actually run for. The test is not whether the charge is large. The test is whether the charge is larger than what the household would otherwise have paid, in money or in what it could not do.

Why can a balance rise in a month when every payment was made?

A rising balance is the point at which debt is most often misread, and the misreading is expensive in a way that has nothing to do with money.

How can a balance rise for seven months in a row?

Now the case, and the reason it exists. The Bhosale household runs on Meghna Bhosale's take-home salary of Rs 39,800/- a month from Sahyadri Freight Services Private Limited, and on whatever Ashok Bhosale's tailoring counter takes in the market lane. In the second year of the case, the lane was dug up for drainage work and stayed dug up for five months. The counter took Rs 52,800/- across the year against Rs 96,000/- the year before, a fall of Rs 43,200/-. Meghna's salary did not change and there was no increment.

Nothing about how the household spends changed. Money out came to Rs 5,44,740/- for the year, below year one's Rs 5,51,040/- only because the two-wheeler loan cleared in January and two of its instalments of Rs 3,150/- fell outside the year. Money in fell to Rs 5,30,400/-. The year ran a shortfall of Rs 14,340/-, and not one decision inside the house produced it. A debt ended and the position still did not close. By then the card's charge had grown past the Rs 3,150/- a month the last instalment released. A lane was dug up. From September, when the buffer had thinned, the groceries went on to a card that had been cleared in full every month since it was taken, and had therefore cost nothing at all.

How Credit-Card Debt Can Compound

Here are the seven months to the rupee. The charge is 3.5 per cent a month on the balance and the minimum is 5 per cent of the statement balance. Read the last column downwards, and read the column beside it at the same time. Every one of those minimum payments was made in full and on the due date, and the balance still rose in every single month.

The bottom row is the check, and it closes exactly: Rs 54,400/- spent, plus Rs 6,447/- of charge, less Rs 12,253/- paid, is Rs 48,594/-. Nothing is hidden in the rounding and nothing is missing. Now look at what the charge column does on its own. The charge starts at nil. Until September the card was cleared in full and cost nothing. Then it is Rs 612/-, and by March it is Rs 1,527/-. Nobody changed the rate. The rate is the same 3.5 per cent in March as it was in October. The charge grew because the number it is charged on grew, and part of what made that number grow was the charge itself. Carrying a balance forward in this way is revolvingCarrying a card balance from one month into the next instead of clearing it. The charge starts at that point and does not stop., and nothing announces it. The silence is what makes revolving the single most expensive habit available to an ordinary household.

What turns one bad month into something that keeps going?

A bad month is a bad month. Households have them constantly and they pass. Three things lined up here, and once they line up the position starts producing its own next month without anybody doing anything.

How a Debt Spiral Can Form

The first ingredient is income that fell. Rs 43,200/- of it, over five months of drainage work in a lane. The second is outgoings that did not follow it down. Most household outgoings are not decisions taken monthly: rent, school fees, the electricity bill, the instalment on a vehicle bought two years ago. The Bhosale household's committed outgoings alone were Rs 37,920/- a month while the two-wheeler loan was still running, and Rs 34,770/- a month once it cleared in January. The third is the charge on the balance, worked out afresh each month on a figure that already includes last month's charge.

None of the three is a decision anybody took, and that is not a comfort, it is the mechanism. The gap between money in and money out has to go somewhere, and the somewhere is a balance. The balance attracts a charge. The charge widens the gap next month. The minimum on a bigger balance is bigger, and it is paid out of the same money in. So the third ingredient feeds the second, and the position runs on its own fuel. A position that runs on its own fuel is a spiralA position that keeps producing its own next month. The size of the problem this month makes the problem next month larger without anybody doing anything.. Naming it precisely means nobody has to reach for a word like carelessness.

There is a moment when it closes, and it is worth being able to see it coming. The spiral is open while the household can still cover the minimum out of income without adding to the balance. The spiral closes at the point where covering the minimum requires putting something else on the card. At that point the payment and the borrowing become the same money going round in a circle, and the balance rises by roughly the whole charge every month. Nothing dramatic happens on the day it closes. There is no letter and no alarm. A month simply arrives in which the arithmetic has changed character.

How long does a balance like this take to clear?

Rs 48,594/- sits on the card at the end of March. Suppose the lane reopens, the counter recovers, and not one further rupee ever goes on that card. The only question left is what gets paid each month. A guess made before the control below is moved is the part that teaches.

The readings that matter can be stated without touching the control at all. At the minimum, the card is clear in 183 months, fifteen years and three months, and Rs 1,44,757/- has been handed over against a debt of Rs 48,594/-. Almost three times the debt, and Rs 96,163/- of it is charge. Push the control one step, to Rs 1,750/- a month, and the answer falls to 55 months: the balance is gone in under five years instead of over fifteen. Push it to Rs 3,000/- and it is 25 months and Rs 72,988/-. The first step off the minimum is worth more than every later step put together, and it is worth them by a margin no ordinary household would guess at.

One wrinkle in that panel is where the two speeds show themselves most plainly. At the very lowest fixed settings, the amount paid is barely above the charge for the month, about Rs 1,701/- at a balance of Rs 48,594/-. Almost nothing comes off, so the months pile up. Because the charge has already been covered, raise the payment a little and the whole of that increase goes against the debt. The curve of benefit is steep at the start and flat later for exactly that reason: every rupee above the charge is working at full strength, and every rupee below it is not working at all.

What are the ways of clearing more than one debt at once?

Most households in this position have more than one thing to clear, and the Bhosale household is ordinary in that respect. At 31 March of year two it owed three amounts. The card, Rs 48,594/-, charged at 3.5 per cent a month. An instalment plan taken for a school tablet for Ira Bhosale, Rs 12,000/- over three instalments of Rs 4,000/- with nothing stated as interest, of which Rs 8,000/- remains. And Rs 15,000/- borrowed from Ashok Bhosale's brother, with no interest, no written date and no schedule. The brother's Rs 15,000/- is the cheapest of the three in rupees and by some distance the most expensive in every other way. Rs 48,594/- plus Rs 8,000/- plus Rs 15,000/- is Rs 71,594/-.

Debt Repayment Methods

With several debts and one pot of money each month, a household faces a question of orderingWhich debt gets the money left over after every required payment has been made, when there is more than one debt and one pot of money.. Every required payment is made on every debt, always, and then whatever is left goes to one of them. The only question is which. Two methods answer it, and they are worth defining separately before either is judged.

The first method sends the surplus to the debt carrying the highest rate, and keeps sending it there until that debt is gone, then moves to the next highest. Its logic is arithmetical: the charge is the thing being fought, so attack it where it is largest. The second method sends the surplus to the smallest balance, whatever rate it carries, and moves up by size. Its logic is behavioural: a debt that disappears entirely is visible, and a household that can see one line vanish is more likely to keep going. Neither method is a product and neither has anything to buy.

How Debt Repayment Strategies Work

Run both against the same household, the same three debts and the same Rs 6,500/- a month, with every required payment made in both cases and only the surplus moving. Highest rate first sends everything spare at the card, and the card is gone in month eleven, after which the whole Rs 6,500/- goes at the brother's Rs 15,000/-. Everything is clear in 13 months and Rs 83,114/- has been paid. Smallest balance first clears the Rs 8,000/- instalment plan, then the brother's Rs 15,000/-, and the card sits on its minimum for six months while that happens, growing slightly less slowly than it would otherwise. Everything is clear in 14 months and Rs 87,971/- has been paid.

Rs 87,971/- less Rs 83,114/- is Rs 4,857/-, and 14 months less 13 months is one month. One month and Rs 4,857/- is the entire difference, and being precise about it matters. Rs 4,857/- is real money. The sum is not nothing. And the decision nobody argues about, whether anything at all is paid above the minimum, has far more at stake.

Where does most of the benefit in a repayment plan actually sit?

The two numbers are almost never seen together, so put them side by side. Choosing between the two orderings, on this household's debts, is worth Rs 4,857/- and one month. Stepping off the minimum on the card alone, from the minimum to Rs 3,000/- a month, is worth Rs 71,769/- and 158 months. The second is roughly fifteen times the first in money and more than a hundred times in time.

None of that is an argument against thinking about the ordering. The argument is about proportion. If a household has an hour to spend on its debts, the hour is worth more spent on finding one more rupee a month than on sequencing the debts perfectly, and any explanation that leads with the sequencing has the proportions the wrong way round. Where that extra rupee comes from, and whether it exists at all in a house where money in has already fallen by Rs 43,200/-, is a real and hard question in its own right.

What does clearing one debt not fix?

Something good happened in this household's second year and it is easy to miss. The two-wheeler loan, taken two years earlier against a Rs 96,000/- vehicle with Rs 14,000/- paid down, ran its thirtieth and last instalment of Rs 3,150/- in January and closed on schedule. Not one instalment was late across the whole of it. A household that judged its year by that single event would conclude it was going forwards.

It was not. Across the same year the card went from nil to Rs 48,594/-, and at 31 March the total owed stood at Rs 71,594/-. One debt ending and a position improving are two different facts. Only the second is worth checking, and only the second includes everything. This is why a household sheet counts what is owed in total rather than counting which lines are still open, and it is why the end of an instalment is a fact about one contract rather than a fact about a household.

How does somebody assessing a household read all of this?

A lender deciding whether to advance money, or an adviser looking at a household sheet, is doing the same two speed calculation set out above, with two shorthand measures standing in for it. The two measures are also the two most honest numbers a household can compute about itself, so knowing them is useful whichever side of the desk somebody is on.

The first is debt to incomeThe share of a period's income that is committed to debt payments in that period. The share says how much room is left, not whether anybody is in trouble.: what share of income is already committed to debt payments. Debt to income has a trap in it. The share can be worked on take-home pay or on gross pay, the two differ enough to matter, and anybody quoting it should say which. At 31 March, with the vehicle loan cleared, the Bhosale household's payments were Rs 2,558/- on the card and Rs 4,000/- on the instalment plan, or Rs 6,558/- in all. Rs 6,558/- is 14.8 per cent of net monthly income of Rs 44,200/- and 13.0 per cent of gross monthly income of Rs 50,400/-. Back in January, with the vehicle loan still running, the same three payments came to Rs 9,180/-, or 20.8 per cent of net and 18.2 per cent of gross. Nearly two points separate the two readings of the same month.

The second is utilisationHow much of a card limit is currently in use, written as a percentage of the limit.: how much of an available limit is currently in use. The Bhosale household's card carries a limit of Rs 60,000/- and the balance at 31 March was Rs 48,594/-, or 81.0 per cent of the limit. Both measures describe how much room is left rather than how hard anybody is trying. Room left is exactly what makes them useful, and exactly why neither should ever be read as a verdict on a household. What a credit record holds, and what moves a score, is covered separately.

The Bhosale household, Meghna Bhosale, Ashok Bhosale, Ira Bhosale and Sahyadri Freight Services Private Limited are invented.
Educational material. Not advice on any investment, tax, budget or market position.