At least that’s how many people feel about debt. But debt can be a good thing! Lending & borrowing increase the overall money supply as it allows for funds to be used by two parties at the same time: the borrower benefits from the immediate availability of funds, while the lender usually earns interest on the loan. Mortgage loans, student loans, and auto loans are incredibly useful in helping people pay for something they could not afford to pay for upfront.
So, debt sounds great now, right?
But as you probably know, not all debt is ‘good’. Many homebuyers become ‘house poor’ by purchasing a home above their affordability limit, preventing them from pursuing other financial and life goals. And if we haven’t experienced it for ourselves, we’ve at least all heard stories of friends or family members burdened with student loan debt for many years after they attended school. Another common way to quickly get yourself into trouble is the high-interest rate nature and ease of obtaining credit cards. There are many factors to consider when deciding to take on new debt or figuring out how to tackle existing debt. Below are just a few important questions to ponder.
Will the loan be used to add value to your life?
It sounds like common sense for us to thoroughly think through major purchases (i.e. house, car, college, trade school, professional school, etc.), but doing so might be even more important when using a loan is necessary for you to afford the purchase. Being realistic about the expected utility, or usefulness, of a purchase decision can go a long way in avoiding unnecessarily burdensome debt.
Are you able to fund your purchase without a loan?
If you are able to use existing savings to fund your major purchase and still keep an adequate amount aside for an emergency fund and other short-term goals, then doing so may be a better option than taking out a loan and paying interest on it.
What interest rate will I qualify for?
A high interest rate can be a strong deterrent against accumulating debt which is why the usual advice of financial advisors is to avoid credit card debt. But when low interest rate loans are available, the decision becomes less clear. An individual may choose to not pay off a loan, even if they could, because they think they can earn a higher rate of return by investing their funds and only making the minimum loan payments. This person may not be wrong, but this way of thinking is not right for everyone. It’s important to acknowledge the inherent risk of any investment since performance isn’t guaranteed.
To one person, debt can be the instrument that helps them achieve their dream of buying a home or becoming a doctor. To another person, debt can be the nightmare that keeps them up at night as they stress about how they will ever pay off their student loans. For better or worse, debt likely plays some role in the financial lives of most people. By better understanding the role of debt in your own life, you might be able to put more money towards your goals and less into the swear jar.