Debt is a bad word these days, but most of us have at least a little bit of it.
Is debt good or bad; a tool or a hindrance? The answer is not always clear-cut and depends on your particular circumstances, but there are some general guidelines to adhere to.
The secret is to be aware of how borrowing fits in to your entire financial situation – be sure to use it as a tool, instead of a crutch. Understanding how debt can help you have a stronger financial portfolio is key to growing your assets, while living a fuller life and retiring successfully.
Debt Is Bad When…
…It costs too much. Borrowing money so that you can spend more is not healthy when it costs too much. When you pay with a credit card and can’t pay it off fully each month, you’re asking for trouble. Paying interest at 19.99% adds precious dollars onto the original cost of your purchase. It feels painless because you only pay a little each month, but it’s money down the drain that you could be using for something else – like your future! Furthermore, think about what you’re putting on that credit card – a new TV? Clothes? These things will all be long gone before you’ve even paid off that debt if you don’t clear out your credit each month.
Download our Loan Payoff Worksheet to see how long it will take you to come clean.
…It hurts your credit. Sure, opening an account at your favorite store will get you a 15% discount today and loads of coupons in the future, but having too many credit cards outstanding is just bad for your credit score and awfully tempting. And, what’s bad for your credit score is bad for your future borrowing rates – meaning higher rates when you need to borrow for something smart, like a new home. For most of us, one national credit card and two to three store cards is enough, so choose wisely.
…You just can’t afford what you’re purchasing. There are times that debt is not only a good option, but the right option. Except for really big-ticket items, you should not be borrowing unless the plan is to pay it off in full in very short order. Borrowing for a couch or TV only increases the cost of that item, even though you just negotiated pretty hard with the salesperson to get his best price! For these types of mid-size purchases, use your credit card to manage cash flow, but pay it off at the end of the month.
Debt Can Be Good When…
…You’re making an “investment” purchase. These types of purchases generally pay dividends in the future. I’m not talking about the stock market; I’m talking about buying a new home or possibly taking a loan for education. Both of these types of purchases are true investments and should more than pay-off in appreciation and higher salaries and outweigh the extra cost of interest. But, beware, like the bad debt reviewed above, too much of a good thing can be bad. If you borrow too much for property (second home or investment property) or even school, you’ll see your rates rise. Too high and it may be too costly to pay back.
…It’s Free! Nothing is really free, but if the sales associate is offering free financing, you may be in for a win. First, check that you can’t get a better deal if you don’t take the free financing. Sometimes, this is the trick. You pay more up front, but don’t have to pay the item off for 12 months. Second, make sure that adding this debt to your portfolio does not hurt your credit score. If your debt-to-income ratio is too high (over 30%), it will drag down your score. If you pass these tests and take the free financing, don’t fall into their other trap of not paying the final balance in time. A lot can happen in 12 months, so either make payments regularly or have a plan to have that money available when the time comes. If not, you may be in for some pretty steep penalties!