Too much debt can be crippling, but some debt, managed wisely, can be a smart financial tool.
Being deep in debt is no fun. Yet most Americans have loans and many college students graduate owing tens of thousands of dollars in student debt. The aggregate level of U.S. household debt has never been higher.1
While you may count yourself among the lucky if you’re debt-free, you may not want to stay that way forever. As crushing as it can be to struggle with more debt than you can afford, an aversion to taking on any debt can be crippling as well. Used prudently, some debt can be a smart financial tool.
Here are four things to consider when deciding whether you should take on debt or not.
The key is to take on only so much debt as you can easily afford to repay. Know how much disposable income you have each month (after accounting for all regular bills and necessities) and make sure not to sign on for debt payments greater than that amount. You should always keep about three months of expenses in an emergency fund, in case your job situation takes a turn for the worse, a friend or family member needs your assistance, or you incur an unexpected expense.
Another key: Differentiate between good debt and bad debt. Obviously, bad debt is high in interest and used to buy something you don’t really need that is unlikely to retain its value. Expensive gadgets or designer clothes are likely culprits.
Good debt carries low interest that may even be tax-deductible. It’s used for something that is likely to appreciate in value or can help you improve your financial position. Taking out debt to buy a house, go back to school, or purchase a car you need to get to work may all fit the bill.
Here’s my checklist for determining if it’s okay to take on debt for a purchase (education included):
- You are buying something that is likely to climb in value or improve your earning ability.
- You can handle the monthly debt payments easily.
- You have an emergency fund in place.
- You are already saving regularly for retirement.
- You aren’t overpaying for the item you’re buying.
- You’re able to get a competitive interest rate for the loan.
You are buying something that is likely to climb in value or improve your earning ability.
You can handle the monthly debt payments easily.
You have an emergency fund in place.
You are already saving regularly for retirement.
You aren’t overpaying for the item you’re buying.
You’re able to get a competitive interest rate for the loan.
A credit card is a convenient way to buy stuff, but it is a terrible way to borrow. If you use a credit card, plan to pay off the balance each month in order to avoid high interest rates on the unpaid balance.
Along with the convenience and potential perks, using a credit card wisely can help you build a credit history and establish a high credit score. That may help you qualify for a lower rate loan when you’re ready for a major purchase.
The more complex your finances, the more you need to think about your personal borrowing the way the chief financial officer at a company thinks about taking on debt.
To a business owner, debt is necessary. Businesses typically need to borrow to fund growth. Likewise, you may need to take on debt to fund your own growth—perhaps taking out a student loan for an advanced degree or applying for a bigger mortgage so you can move to a larger home in a better school district if you have children.
At that stage, you may find yourself borrowing for some goals at the same time that you’ll need to invest for the long-term to meet others. Be sure to save steadily for your own retirement. Seeing your retirement savings grow tax-deferred, even as you borrow to meet other financial demands, can be a comfort.
Start saving early to fund your children’s college educations, perhaps through a 529 plan where earnings grow tax free and contributions may be deductible.
By saving early, you can help your children avoid struggling with large amounts of student loans when they are starting their careers. Even better, you can dodge the temptation to deplete your own savings to help them foot the bill.