Understanding Debt Basics

Debt is a financial tool. Like any tool, it can help you build wealth or destroy it—depending on how you use it.

What Is Debt?

The Simple Definition

Debt = Money you borrow that you must pay back, usually with interest.

The Components of Debt

Every debt has these parts:

Example

You borrow ₹1,00,000 at 12% for 3 years:

• Principal: ₹1,00,000
• Interest rate: 12% per annum
• Term: 36 months
• EMI: ~₹3,321
• Total paid: ₹1,19,556
• Interest cost: ₹19,556

Types of Debt

Secured vs. Unsecured

Good Debt vs. Bad Debt

Good debt helps you build wealth or increase earning capacity.

Bad debt finances consumption or depreciating assets.

The Reality

Most debt falls somewhere in between. Context matters.

Common Debt Types in India

Home Loan

• Typical rate: 8.5-10%
• Term: 15-30 years
• Secured by: Property
• Tax benefit: Section 24 (interest), 80C (principal)

Car Loan

• Typical rate: 8-12%
• Term: 3-7 years
• Secured by: Vehicle
• Tax benefit: None

Personal Loan

• Typical rate: 10-24%
• Term: 1-5 years
• Unsecured
• Tax benefit: None

Credit Card

• Typical rate: 36-42% per annum
• Revolving credit
• Unsecured
• Tax benefit: None

Education Loan

• Typical rate: 8-14%
• Term: 5-15 years
• Often unsecured (smaller amounts)
• Tax benefit: Section 80E (full interest deduction)

Gold Loan

• Typical rate: 9-15%
• Term: Flexible
• Secured by: Gold jewelry
• Tax benefit: None

How Interest Works

Simple Interest

Interest calculated only on principal.

Simple Interest = Principal × Rate × Time

₹1,00,000 × 12% × 3 years = ₹36,000 interest
Total repayment = ₹1,36,000

Rarely used in India for loans.

Compound Interest

Interest calculated on principal + accumulated interest.

Amount = Principal × (1 + Rate/n)^(n×t)

Where n = compounding frequency

Most loans compound monthly.

Reducing Balance vs. Flat Rate

Reducing balance (most common):

• Interest charged on remaining principal
• As you pay, principal reduces, interest reduces
• Actual cost = stated rate

Flat rate (some loans):

• Interest always on original principal
• Even though you’re paying down principal
• Actual cost = ~2× stated rate

Example comparison:

Always ask: “Is this reducing balance or flat rate?”

Credit Card Interest

Credit cards are the most expensive debt:

Annual rate: 36-42%
Monthly rate: 3-3.5%
Daily rate: 0.1%

If you carry ₹10,000 balance:
Monthly interest: ₹300-350
Annual interest: ₹3,600-4,200

Plus late fees, over-limit fees, etc.

The EMI Formula

EMI = P × r × (1 + r)^n / [(1 + r)^n - 1]

Where:

• P = Principal
• r = Monthly interest rate (annual rate ÷ 12)
• n = Number of months

EMI Breakdown Over Time

For a ₹10,00,000 home loan at 9% for 20 years:

Early years: Mostly paying interest Later years: Mostly paying principal

This is why prepayments early in loan term save more.

Debt Ratios You Should Know

Debt-to-Income Ratio (DTI)

DTI = Total Monthly Debt Payments / Monthly Income × 100

Example:

• Income: ₹1,00,000
• EMIs: ₹35,000
• DTI: 35% (Manageable)

FOIR (Fixed Obligation to Income Ratio)

Banks use this to approve loans:

FOIR = All Fixed Obligations / Net Monthly Income × 100

Most banks cap at 50-60% FOIR.

Credit Utilization

For credit cards:

Utilization = Used Credit / Available Credit × 100

When Debt Makes Sense

Appropriate Uses

✅ Home purchase — Can’t save ₹50 lakh cash easily ✅ Education — Increases earning potential ✅ Medical emergency — Health is wealth ✅ Business investment — Generates returns >loan cost ✅ Asset with appreciation — If return > interest rate

Inappropriate Uses

❌ Lifestyle inflation — Living beyond means ❌ Vacations — Pay interest for years on memories ❌ Shopping — Depreciating items ❌ Investing on leverage — Risky ❌ Covering other debts — Debt spiral

The Cost of Debt: Real Examples

Credit Card Minimum Payment Trap

₹1,00,000 credit card balance at 42% interest:

Personal Loan vs. Credit Card

₹1,00,000 borrowed:

Savings by using personal loan: ₹1,20,000

Key Terms Glossary

Key Takeaways

• All debt isn’t equal — some helps, some hurts
• Interest compounds — small rates become big costs
• Reducing balance < flat rate — always confirm
• Credit cards are expensive — 36-42% interest
• DTI under 30% — is the healthy target
• Context matters — same debt can be good or bad
• Understand before borrowing — know all terms

Next: Creating a Debt Inventory — List and organize all your debts.