Is all debt bad? Not necessarily. Certain types of debt are either beneficial or detrimental as we try to improve our finances.
For instance, you can pay off debt consistently (like paying off a credit card in full each month) and establish good credit so that you can qualify to borrow money at lower interest rates in the future. Or, in a worst case scenario, you could get stuck in a payday lending scheme. These loans have high interest rates that are meant to be short-term. If the loan lasts longer than you anticipated, you may end up paying over 150 percent APR (or more). This could be damaging to your finances for years to come.
There are certain types of debt we want to avoid. First on the list: any debt we can't afford to pay back. Perhaps the monthly payments are too large or the loan isn't amortized and there is a balloon payment that will be difficult for us to cover. We also want to avoid high interest rate debt (like credit cards or the payday loans mentioned above).
Additionally, we want to avoid consumer debt (think credit cards) or living beyond our means (like a home equity line to pay for a vacation). In these cases we're borrowing for lifestyle choices, which are not sound financial purposes. These are the types of items we should be able to forgo or save for. They might also be purchased from an emergency account if appropriate (e.g. when your refrigerator goes capoot).
The cost of a college education has become more and more expensive over time (outpacing inflation). Attending college commands higher salaries, increasing one's earning power. Additionally, there are less tangible but equally important benefits to attending college (e.g. the opportunity to pursue a fulfilling career). Debt for education can improve your position, but when incurring debt, we need to weigh potential advantages against the price and/or terms of the loan. Essentially, when selecting a school, we need to assess whether the cost outweighs the value.
The same applies when buying a home, which generally should not be considered an investment. Rather, it is a large purchase that will have an impact on your financial situation. The right mortgage can make a house affordable now, whereas saving for the entire amount for the same house might not be possible. With the right terms, a house can be paid for out of cash flow each month. If the monthly payments are truly affordable, over time you'll improve your financial position (even if housing prices don't go up) because eventually you'll own your house outright. You'll also be enjoying the use of the home over the entire length of the mortgage and beyond.
Borrowing to invest in a well-planned business you are launching is another example of an appropriate use of debt.
Terms, Cash Flow, and Affordability
Beyond the reasons for taking out a loan, the specifics of what the loan "looks like" are critical in assessing good vs. bad debt. You need to know the terms. This includes the amount you are borrowing, interest rate (fixed or variable), length (how long the loan lasts) as well as payment amount and frequency. It's not just about the amount you are borrowing. The terms of the loan will affect whether or not you can afford the loan and pay back the money.
In addition to the numbers, there are emotional factors to consider. Some people feel uncomfortable owing even small amounts to anyone. Emotionally, they don't want to be in debt even if it improves their financial position. Educating yourself about debt and how it might affect your financial situation might negate these feelings. However, you don't have to make decisions purely from a rational financial perspective. Taking your comfort level with debt into account is an important factor.
Be wise and purposeful when borrowing money and use "good" debt to your advantage. Continue to pay it off so that you can SaveUp!
This post was written by SaveUp's personal finance contributing writer, Catherine Hawley, CFP®.