Debt is a tool to leverage our finances so we can purchase our homes, our cars, go to school, and buy the many other things that we may want. I hear many people say that any debt is bad debt but if used responsibly, it can be a great tool to get ahead. After all sometimes it takes money to make money. But how do you know when it is a good idea to finance something versus waiting, saving, and paying cold hard cash for something?
Purpose of the Purchase
Before taking another’s money to finance a purchase, consider what your end-goals are and go from there. For instance, with student loans, are you pursuing a degree in an area of study that once you graduate will provide you a career with a good income? Are you planning to purchase a home to fix up and sell at a higher price or is it going to be your home for the next 20 years? Knowing what you are buying and the purpose of that purchase can help you determine whether it a good idea to finance.
Potential For Appreciation
Simply put, anything that has the potential appreciation or has the potential to provide a stream of income, can be a circumstance when it makes sense to incur debt to make that purchase. So applying for a mortgage or taking out student loans to pursue a high-paying career can be a good money move. Ever wonder how real estate investors decide whether buying a property is a good business decision? They look at what they potential cash flows are going to be in exchange for their initial cash outflows. Every purchase should provide them with a positive internal rate of return.
An example would be purchasing an investment property for $100,000, spending $20,000 to make it a desirable rental, and charging a tenant $1,200 a month to rent the property. Considering you clear 80% of that after repairs and taxes you are left with $960 a month in rental income or $11,520 a year. If you kept this rental property for 3 years and sold it in the fourth for $150,000, then you would have an internal rate of return of 12.8%! You can test out other scenarios through this calculator here.
When To Avoid Debt
Cars, clothes, and other items that have no potential to appreciate over time should be weighed carefully as to whether it should be financed. I know there are things like classic cars that can potentially be worth more over time but unless you are knowledgeable in a certain area or are skilled enough to fancy something up and resell it, you should probably avoid it. High credit card balances from dining out and clothes shopping raises a lot of red flags. Driving a brand new car off the lot and having the value immediately drop 20% makes no sense even though it feels pretty darn good. Its just a good idea to ask yourself, “is this item going to appreciate in value over time?” If the answer is no, you are better off paying cash.
Debt Can Over Take You
Like mentioned before, debt can be a great tool to help you grow your net worth over time but taking too much on can also cause some BIG problems! In my opinion, I consider a good debt to income ratio to be no more than 35%. You calculate this percentage by taking your total payments to service any debt, and divide it by your gross monthly income. The lower this percentage is, the better you are able to weather tough times.
One of my favorite books, even though it was written way before my time, is by George S. Clason and is titled The Richest Man In Babylon. Practical money advice to lower your debt and fatten you bank account is always a good thing! If you find that your debt to income ratio is over 35%, take steps to get back on track. That means either lowering your debt payments through payoffs and refinancing, or increasing your gross monthly income. Are you withholding too much from your paychecks, can you sell your no longer needed items on the side? There are several ways you can reset your finances. Take a look at ways you can decrease your payments and/or increase your income.
Disclaimer: I am a CERTIFIED FINANCIAL PLANNER TM (CFP®), but I am not your CFP® or financial advisor. The information in this article is for general informational and entertainment purposes only and does not constitute financial advice. This article does not create a financial planner-client relationship. The author is not liable for any losses or damages related to actions of failure to act related to the content in this article. If you need specific financial advice, consult with a licensed financial advisor or CFP® who can tailor advice regarding your specific circumstances. Additionally, sometimes I use affiliate links to support my website. This means I may earn a small commission, which is no additional cost to you, for referring and discussing products and services that I personally use, or have used, and trust. Thanks for your support!