What Are The Rules To Using Debt Responsibly?

August 5, 2019

Part of good management of your personal finances is understanding when and when NOT to borrow money. For many, getting into debt is not done by choice, but out of necessity. You need a car; you need to finish your education; you need a new roof on your home.

But, it’s easy to abuse debt, getting yourself into a situation where you are unable to pay the debts off in a reasonable amount of time and setting you back years or even decades. You can avoid the pitfalls of debt though by following some simple rules.

Debt should be used as an investment for your future.

Ask yourself, are you getting into debt to fulfill a short-term desire? Or are you utilizing the borrowed funds to make an investment for your future? Borrowing money to purchase new clothes, electronics, or a high-priced meal is never a good idea. These are disposable assets which do nothing to enhance your wealth in the long term and should only be purchase with savings.

But borrowing money to make your future better could make sense.

Student loans are a great example. US Government statistics show that a bachelor’s degree leads to a 60% increase in annual pay over a high school diploma. This means a high school graduate making $40,000 a year can reasonably expect their pay to increase to $64,000 a year upon completion of a 4-year college degree. That’s $24,000 a year or $960,000 over a 40-year career.

A mortgage is another example of an investment in the future, for two reasons. First, you need to pay rent anyway, so why not make payments to a bank, building equity and your ownership stake? Each payment increases your net worth by paying down the balance of the loan. Additionally, real estate values tend to increase over time, further increasing your net worth.

Credit card debt should only be used as a convenience.

It’s important for younger people to begin using credit cards as a means of building their credit rating. Without a credit history, it can be difficult to qualify for a mortgage or car loan, or even complete an apartment rental application. But credit cards should always be used responsibly.

There is a difference between using a credit card to make purchases because it’s more convenient than cash and making purchases that you really can’t afford. Never charge more on your card than you can afford to pay off within the next 30-days. If you absolutely need to charge more than that, never carry a balance more than 30% of the available credit, and work to quickly pay off the balance over the next several months before making more purchases.

Understand the interest rate and fees.

You need to understand the interest rates, fees, and pay off details before accepting the money to make sure you are not getting ripped off.

Pay day loans are a classic example of a type of loan that should be avoided at all cost largely because of high interest rates and fees.

Here’s an example. Let’s say you are expecting a paycheck of $1,300 in 2-weeks, but you need money now. A pay day lender may be willing to front you $1,000 today, and when you receive your paycheck, they will take the full $1,300. That’s $300 in fees and interest which equates to an annualized interest rate of 780%! As a comparison, the average 30-year mortgage charges about 4.5%. Credit card interest rates range between 10% to 25%.

Due to high fees, other types of debt such as finance company loans, tax refund anticipation loans, credit card cash advances, or loans from pawn shops.

If you need to borrow, borrow the minimum you can get away with.

It may sound silly right? Why would you borrow more than you need? But once you are approved for a line of credit, it’s easy to get carried away. This often happens with car loans.

I’ve consulted with so many people who purchase expansive cars, justifying their extravagant expense with the statement “I can afford the payments”. I’m not saying you shouldn’t be driving an $80,000 car – buy only if you can pay cash for it. If you are borrowing money to purchase a car, you should not be borrowing $80,000 when a $25,000 will get you where you are going just as quickly.

There is nothing wrong with utilizing borrowed money if you are doing it responsibly. Debt should be used as a convenience, or to invest in your future. It should not be used to fund your current lifestyle or for purchases that you can’t afford to pay cash for.