Debt has gotten a bad rap lately, and for good reason. American debt is burdensome. 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 — 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. “Secured debt” is less risky for a lender — and costs less for the borrower — because an item of value like a house or car can be collected if the borrower doesn’t pay. When a lender has little or no way of guaranteeing payback — like with a personal loan or a credit card — debt costs more. This is precisely why a good credit score is so crucial for getting a good interest rate. If you look at it from a lender’s 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’s no doubt that debt can be a useful tool. 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 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’s unlikely that most people can afford a home without debt and this type of debt is relatively cheap, most consumers can take on 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 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 is a type of reasonably priced debt that may be necessary. It’s certainly less attractive than mortgage debt because cars depreciate quickly, while homes generally appreciate. But today’s cars are expensive and yet essential for most of us to get to work, so auto loans 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 can be a necessary evil. If you or a loved one gets sick or has an accident, you’re 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’re in this situation, be sure to take the initiative to manage this debt so that it doesn’t get sent to a collections agency, where it could hurt your credit score.
Credit card debt 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 build a financial credit history that in turn helps you get insurance, rent a home or get a 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’t 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 credit card debt marks the point on this list where debt is no longer potentially augmenting your financial well-being.
Personal loan debt from a bank or credit union may be necessary to pay for problems or emergencies that crop up. However, it’s 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 savings account so you avoid debt that doesn’t move your financial life forward.
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