Not all debt is bad
Debt has gotten a bad rap lately, and for good reason. Recent NerdWallet data show that the average U.S. household with debt carries聽聽and $130,922 in total debt, with the average consumer spending more than聽$2,500 a year on credit card interest. A number of well-respected financial self-help gurus even tout programs that advocate a cash-only, debt-free life.
So, should sensible people say no to debt? Probably not 鈥� because not all debt is bad. If you manage debt in a smart, planned way, you can exploit it to increase your wealth rather than let it use and deplete you.
How debt works
In simple terms, borrowing money is like paying for any kind of service. You pay to have a person to clean your house or fix your car, and when you borrow money, you pay for that service as well.
Lenders charge borrowers for the use of their money, and the more worried the lender is about getting paid back, the higher the cost. 鈥淪ecured debt鈥� is less risky for a lender 鈥� and costs less for the borrower 鈥� because an item of value like a house or car can be collected if the borrower doesn鈥檛 pay. When a lender has little or no way of guaranteeing payback 鈥� like with a personal loan or a credit card 鈥� debt costs more.
This is precisely why a good聽聽is so crucial for getting a good interest rate. If you look at it from a lender鈥檚 point of view, you can see the concern. A good credit score means that the borrower has a reasonable amount of debt with regard to income, low credit balances, positive credit behavior over a long period of time and a record of paying bills on time. The lender feels confident that the borrower will pay back the loan on time.
Types of debt
There鈥檚 no doubt that debt can be a useful tool.听Just think about how long it would take to save up to buy a home entirely in cash. Employing debt in a careful way can help you build a successful financial life. This list shows the kinds of debt that you could incur, from most desirable to least (indebtedness to parents, significant others or generalized guilt not included!):
- Home mortgages, home equity loans or reverse mortgages聽are essentially the least expensive type of debt you can incur and offer the best value or outcome you can get from borrowing money. These days you can potentially get a fixed-rate mortgage for around 2.75%. Since it鈥檚 unlikely that most people can afford a home without debt and this type of debt is relatively cheap, most consumers can take on聽mortgage debt with confidence. Using the equity in your home to borrow money through a home equity loan is another low-interest way to borrow if you are sure that you can pay the loan back. A reverse mortgage, where you borrow against the value of your paid-off home, can offer a way for retired people to meet their monthly expenses if they are short on cash.
- Student loan debt聽can also pay off handsomely in the long run. Earning a degree from a reasonably priced college in a well-paying professional field can ensure a lifetime of steady work and consistently high earnings. However, incurring $120,000 of student loan debt for a degree in an obscure major from a private college would probably be a poor choice in terms of debt.
- Auto loan debt聽is a type of reasonably priced debt that may be necessary. It鈥檚 certainly less attractive than mortgage debt because cars depreciate quickly, while homes generally appreciate. But today鈥檚 cars are expensive and yet essential for most of us to get to work, so聽聽may be unavoidable. Choosing the most dependable, least expensive vehicle that will meet your needs will help ensure this type of debt is of value to you.
- Medical bill debt聽can be a necessary evil. If you or a loved one gets sick or has an accident, you鈥檙e going to be hard-pressed to say no to all available medical care, no matter how expensive it is. But once the crisis is over, you can be left with crippling bills. Medical debt can often be managed at a low interest rate if you work with the medical provider to make monthly payments. If you鈥檙e in this situation, be sure to take the initiative to manage this debt so that it doesn鈥檛 get sent to a collections agency, where it could hurt your credit score.
- Credit card debt聽can be a useful tool for managing your money because it helps during emergencies. Credit cards are safer and more convenient than carrying cash, and they allow you to easily make large purchases. Using a credit card also helps you聽聽that in turn helps you get insurance, rent a home or get a聽mortgage more easily and at lower rates. Some credit cards also yield travel and other rewards. But the primary disadvantage of a credit card is the same as its primary advantage: It lets you spend money you don鈥檛 have. Months or years of just making the monthly minimum payment add a lot to your original bill when the credit card company is charging you 21% interest. That kind of聽聽marks the point on this list where debt is no longer potentially augmenting your financial well-being.
- Personal loan debt聽from a bank or credit union may be necessary to pay for problems or emergencies that crop up. However, it鈥檚 less desirable to use a personal loan to pay for a vacation or a wedding. Make a promise to yourself to use a personal loan only to solve a problem and instead save up for that vacation or wedding with a聽聽so you avoid debt that doesn鈥檛 move your financial life forward.
- 401(k) loan debt聽鈥斅爓hen you borrow money from your 401(k) retirement plan聽鈥斅爄s another type of debt that is best avoided. Even though you may be able to borrow at a competitive interest rate, you can聽run into penalties if you can鈥檛 pay the loan back in the prescribed period. And if you lose your job, your employer can require that you pay the loan back immediately. It鈥檚 true that you can avoid penalties in certain circumstances, like for homeownership, education or medical costs, but it is really a mistake to borrow from your 401(k) unless you are in dire straits. You don鈥檛聽have聽to buy a house or go to school, so it is better to wait until you can afford to do so without tapping retirement money. Most Americans are falling short in saving for retirement, so borrowing retirement money for any reason other than a desperate need is usually a mistake.
- High-interest-rate loan (title loan, payday loan or 鈥渃heck-into-cash鈥� loan) debt聽has no place in a healthy financial life. You鈥檒l pay a聽聽if you use this type of loan. Though the fees seem small, say $15 for a two-week, $100 loan, often borrowers end up continually rolling over their loans, extending the term and incurring additional fees each time. The Federal Trade Commission explains the problems with these kinds of loans: 鈥淭he cost of the initial $100 loan is a $15 finance charge and an annual percentage rate of 391%. If you roll over the loan three times, the finance charge would climb to $60 to borrow the $100.鈥� Although this type of loan is so expensive that it really should be avoided, it is聽quite common. According to industry trade group the Community Financial Services Association of America,聽聽(about one in six) American households 鈥斅爉ostly in lower socioeconomic levels. Before you take out a loan, consider聽.听聽using apps like NAV or ActiveHours to access your paycheck early, or selling items you don鈥檛 need. And if you must turn to a payday loan, compare rates among banks, credit unions and payday lenders.
Debt discipline
Avoiding and minimizing unwanted debt isn鈥檛 any easier than reducing your waistline. Both take discipline and sacrifice. Neither reduction experience is very fun. However, seeing your debt go down and then disappear would be really fun. Ultimately, feeling in control of the debt you purposefully decide to incur is ideal.
Remember, not all debt is bad, and some debt is probably necessary to achieve the goals you set for yourself and your family. So make sure you educate yourself about debt to make your financial life as positive and abundant as possible.
聽is a certified financial planner and fee-only investment advisor with聽聽in Aiken, South Carolina.
This article first appeared at .
