How to Use Debt – Properly!

2 - How to Use Debt - Header ImageIs debt worth it?

This is the essential question when it comes to financing expenditures – not just for consumers, but for businesses and even governments. While debt can help to finance important investments and build wealth, it can also become an unmanageably expensive burden. That’s why choosing which type of debt to use and when is so important.

Read on to learn how to distinguish practical from dangerous debt, and how to make the most of both.

Practical debt

 At its most basic, a practical debt can help you build wealth by financing something that has the chance to rise in value. In these situations, the cost of the debt is expected to be lower than the eventual value of the asset or expenditure.

Practical uses of debt can include:

  • A home
  • Higher education
  • New business
  • Investment assets

But the key word when it comes to practical debt is potential: debt is one of those areas in life where there are no guarantees.

Your new house may decline in value (or fail to grow as much as you thought it would), and you could still have trouble finding a new job after taking out loans that Master’s degree (or end up with lower-paying one than you expected). The business idea that’s a sure thing? It might not be.

This is why even practical debt requires a prudent and realistic assessment of its potential benefits.

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How to make a decision about “practical” debt

Ask yourself these questions:

  • What is the total amount of money you’ll need? Can you partially finance your investment through savings?
  • How much will the loan cost – both in terms of interest and the total monthly payment? Is there a chance it could change (as with an Adjustable Rate Mortgage)?
  • How long will your repayment period last?

Answering these questions will give you a good idea of the cost of what you’re doing. From there, you can start to investigate the potential payoffs of the investment itself:

  • Is the purchase or investment likely to be worth the cost? In other words, if you’ll be paying $500 in student loans for 10 years to go to a particular school, are you clear on whether the anticipated benefits to your salary and your career make up for it?
  • Is there a cheaper way to accomplish the same goal? For example, if you’re choosing between similarly-ranked public and private schools for your graduate program it could be more prudent to choose the lower-cost option.
  • What are the risk factors involved and what could go wrong? This is a good question to ask to stress test your assumptions. What will you do if you have trouble finding a job? For a mortgage, what if housing prices fall? For business loans, what happens if your business doesn’t get off the ground?

Thinking through these difficult questions can help you build a more robust and resilient plan. That’s the difference between debt that is potentially good for you and debt that could actually be good for you.

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Dangerous debt

 While practical debts is used to acquire something that could go up in value, dangerous debt finances purchases that will never go up in value. With bad debt, it is certain that whatever you use the debt to finance will lose value over time.

In other words, with dangerous debt you’re paying more over time for something that is worth less.

 Dangerous debt is usually used to purchase things like:

  • Cars (especially new ones)
  • Consumer goods like clothes and household products
  • Services like car repairs and cleaning
  • Travel and vacations

This debt is dangerous for two reasons: you’ll end up paying even more for the product than it was initially worth, and it will lose value over time. Over time, the costs of the purchase will increasingly outstrip the benefits.

An example of dangerous debt

 Cars are a great example. The moment you purchase a new car, it loses value. Edmunds estimates that a new car loses 9% of its purchase value the moment it is driven off the lot; in its first year, the car loses 19% of its purchase value.

That’s a cost people who love new cars may be willing to pay, but if you use debt to finance the purchase you’ll pay even more. Suppose you take a loan for the full value of the car and pay 5% interest per year. If the car cost $20,000, you’ll not only “lose” $3,800 in value in the first year due to depreciation, you’ll also lose an extra $1,000 in financing costs.

Managing the risk of dangerous debt

What if you need a new car to get to work and don’t have the assets to pay cash?

Dangerous doesn’t mean definitely catastrophic – it just means that you’ll need to be very careful. In situations where you have few alternative options, your goal should be to minimize the cost of your dangerous debt.

In the example of a car, consider the following:

  • Buy cheaper, and consider a used car that has already seen significant depreciation. That doesn’t necessarily mean an old car! The rate of depreciation falls over time, from 19% in the first year to 11% per year over the next 3 years. That means a 3 year old car is typically “worth” 58% of its initial purchase price and will still likely have a lot of life left.
  • Fund as much of the purchase as you can with cash (without risking your emergency fund) to reduce the amount borrowed.
  • Research your options to get the most reliable car you can. Again, that doesn’t necessarily mean the most expensive!
  • Shop around to get the cheapest loan you can. This is where a great credit rating can pay dividends – just remember that variable rate loans can look cheap today but become more costly later, as can loans with a number of embedded fees.

While this example focused specifically on cars, these principles apply to nearly every dangerous debt. While your first priority should be to resist using dangerous debt when you can, sometimes it’s difficult or impossible to avoid. In those cases, reducing the amount you borrow and making it as cheap as possible are critical.

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Let Us Help!

We can discuss this topic and more at a complimentary appointment. As a bay area retirement planning coaches, we can give you a review and make suggestions based on your retirement objectives.

Important disclosures

The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by United Planners.

To determine which investments may be appropriate for you, consult with your financial professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk.

Neither diversification nor asset allocation can ensure a profit or prevention of loss in times of declining values. United Planners does not render tax advice.

Information for this article was compiled from the following resources:
https://www.edmunds.com/car-buying/how-fast-does-my-new-car-lose-value-infographic.html
http://www.bankrate.com/finance/credit-cards/current-interest-rates.aspx

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