When money is borrowed wisely, it can be invested to generate income and increase net worth, whether by a small business entrepreneur or a student attending college. When money is borrowed unwisely, the debt payments can crowd out other needs and lead to impoverishment, foreclosure or even bankruptcy. Knowing the difference in advance is key.
The Many Flavors of Debt
Debt takes many forms. Some debts are secured by an asset, known as collateral, such as your car (for auto loans) or your home (for mortgages and home-equity lines of credit). If the borrower doesn’t repay the debt, the lender can repossess the car or foreclose on the home. Other debts are unsecured, such as credit card balances and student or personal loans. (For more, see: Good Debt vs. Bad Debt.)
Unsecured debts, since they have no collateral, nearly always incur higher rates of interest. Some debts have fixed terms and payments, so that the debt is repaid (amortized) over a specific number of months or years. Others represent revolving credit, where the borrower and lender agree on a total amount of available credit but there is no fixed repayment schedule. Credit cards are a common example.
With any debt, you’ll want to know the basic terms. For example: What is the annual percentage rate (APR)? Is it fixed or variable? How much will the monthly payments be? For how long will I be making payments? Can I pre-pay without penalty? What fees and other charges will I incur when borrowing?
Beyond the basics, however, it’s smart to consider these bigger-picture financial questions that look to your total wealth and net worth before pulling out your credit card or signing on the proverbial dotted line.
How Much Total Debt Can I Afford?
It’s important to keep the big picture in mind when making any borrowing decision because the total amount of your debt can affect your credit score, your ability to obtain a mortgage or car loan, and many other aspects of your financial and personal life.
A common rule of thumb used by mortgage financiers, such as Fannie Mae, involves your debt-to-income ratio which is the percentage of your gross (pre-tax) monthly income that’s devoted to debt payments. Under this rule, your monthly payments for all debts - including not only mortgage payments but also credit cards, student loans, auto loans and so forth - generally shouldn’t exceed about 36% of your gross monthly income.
Borrowers with higher credit scores can push this ratio to 45% or even 50%. Specific to mortgages, the Consumer Financial Protection Bureau sets the maximum debt-to-income ratio for a qualified mortgage at 43%. While there are exceptions to these rules, it’s nevertheless important to understand that these ratios represent a kind of risk score for your financial health. Exceeding them can make your financial position precarious. (For more, see: How to Manage and Consolidate Your Own Debt.)
For example, Mary earns $60,000 per year at her job, or $5,000 a month before taxes. Her total of all debt payments should ideally be less than $2,250 - $2,500 (45% - 50% of $5,000). Mary’s mortgage payment shouldn’t exceed about $2,150 per month (43% of $5,000).
Will the Loan Payments Last longer Than What I’m Buying?
A second criterion for determining if taking on a debt is reasonable is whether the loan term is similar to (or less than) the life of the asset you’re acquiring, whether it be a car, house or college education.
A 30-year mortgage usually makes sense for a home purchase because the asset life (the house) matches or exceeds the loan term and also because the home often appreciates in value. For student loans, terms of 10 years are standard for federal and many bank loans. But terms of up to 25 or even 30 years are sometimes available.
That often makes sense, even with the additional interest payments that come with an extended loan term, provided the college or graduate school education results in a career that can provide a higher lifetime income stream and increase one’s net worth. Long-term car loans, on the other hand, may not be a good idea. Cars, especially new ones, depreciate rapidly. Unless you’re planning to keep a car for as long as possible, it’s best to finance the car purchase over the shortest possible time period so that depreciation and interest costs are minimized.
For example, Linda takes out a five-year loan for $35,000 to buy a new SUV and pays 4% interest. When she drives the car off the lot, it will lose about 10% of its value and by the end of the first year it will have depreciated by a total of about $7,000 (20%). After one year of making payments, Linda will still owe $28,548 on the SUV, but it will be worth only $28,000. Meanwhile, Linda’s monthly payment will be $644.58 and she’ll pay a total of $38,675 over the five-year loan term, with $3,675 of interest.
Will This Debt Help Increase My Net Worth?
In financial planning, a fundamental goal is to increase net worth (the difference between your assets and your liabilities) over time, whether by growing income/assets, decreasing debts and other liabilities, or both. Some types of debt, though, such as student, business or mortgage loans, can actually help to increase your net worth. (For more, see: Saving vs. Paying Off Debt.)
For example: You buy a house for $500,000, putting down 10% ($50,000) and financing the rest with a $450,000 mortgage at 4%. The monthly mortgage payments will be $2,148.37. Note that your net worth at this point hasn’t changed at all. Originally, you had $50,000 in cash. Now you have a house worth $500,000, plus a debt of $450,000, for the same net worth of $50,000 ($500,000 – $450,000), ignoring closing costs and other home acquisition expenses.
Now assume that the home increases in value by 5%, or $25,000, after one year. It’s now worth $525,000, so your home equity has increased by $25,000. Moreover, you’ve paid an additional $7,925 in principal as part of your mortgage payments over that year, further increasing your equity in the home while reducing your debt to $442,075.
On the other hand, you’ve also paid $17,856 in interest costs during that first year. Your net worth after the first year is now $65,069, leaving you $15,069 or 30% wealthier ($65,069 – $50,000). Fair market value of the house is $525,000, minus remaining mortgage debt of $442,075, minus interest payments made of $17,856 = $65,069 net worth.
For simplicity, we’ve ignored the potential income tax deductibility of mortgage interest, which would further increase your net worth. Of course, you’ll have also paid property taxes (also deductible within limits) and home maintenance expenses during the year, which would reduce the gain in your net worth. And in some cases home values can decrease as we saw during the 2008-2009 financial crisis and its aftermath. Nevertheless, the example illustrates that some debts can be beneficial by financing investments that increase your net worth.
Do I Really Need to Borrow This Money Now?
This is the simplest of the questions, but also the easiest to avoid asking ourselves. Sometimes the answer is obvious. For example, you need a car to drive to work and you need to borrow to finance the car.
At other times, though, temptation can easily outweigh prudence, especially with a credit card in hand. Credit cards make it easy to rack up large debts with small individual purchases and the conveniently small minimum payments mask the often sky-high interest rates. Those currently average around 16% but can range up to 22% or more.
Most Americans don’t pay off the balance each month, so we end up incurring debt and paying those rates. Paying cash instead of using credit cards is one way to slow down this process of impulse buying and incurring debt. Another is simply waiting 24 hours before clicking on the “buy now” button or making the purchase, which often results in a decision not to buy after all.
The Long View
Debt is a financial tool that, like many things in life, can be both helpful and harmful. Until the mid-19th century, people who couldn’t pay their debts were often sent to debtors’ prisons. Modern bankruptcy laws, fortunately, allow people burdened with debt to receive a chance at a fresh start. In Poor Richard’s Almanack, Benjamin Franklin said, “In buying Goods, ‘tis best to pay ready money.” This is because we save on the costs associated with buying on credit. Similarly, when making purchases of any type, it’s best to avoid needless debt financing and to be both informed and smart in our use of debt when we do borrow. (For more from this author, see: Save Money With the Right Student Loan Repayment Plan.)