Between student debt, credit card debt, auto loans and home loans, I think it’s fair to say that we are facing a debt crisis in the U.S. Part of the problem is that we consumers were never taught in school how to manage debt safely. If you follow the two rules outlined here, you should be able to use debt to your advantage without taking on undo risk.
Debt rule No. 1
The first rule: Do not borrow money for any asset that is not expected to appreciate in value throughout the loan period.
Real estate, stocks and bonds are examples of assets that generally increase in value over time. The value of commodities such as industrial metals and energy products varies over time primarily based on supply and demand. Artwork, jewelry and other collectibles may see appreciation or depreciation depending on changing collector preferences.
Just about all other household items – cars, furniture, clothing, appliances, electronics, etc. – decline in value after purchase due to advances in production that enable the creation of lower-priced or better-performing substitutes in the future.
Why is it a problem to borrow money to pay for a depreciating asset? Because you cannot use the asset to help defray the cost of the loan should an unforeseen circumstance arise. Suppose you are holding a car loan that is halfway paid off. The amount owed at that point is likely to be more than the current value of the car. If you were to lose your job and needed money, even after selling the car you’d still be in debt.
Is it safe to use credit cards to pay for household items? Yes, but only if you pay off the balance in full every month. Otherwise those items may end up costing you a lot more than you expected or can afford.
Unfortunately, even for appreciating assets, the time period may not always coincide with the loan period. I would consider 15- and 30-year home mortgages to be generally safe because home prices rarely decline or remain depressed for such long periods. I would not recommend borrowing money to invest in stocks and bonds, however. Although their prices historically increase in value long term, they can fluctuate pretty wildly over the short term. That is what destroyed Lehman Brothers in 2008.
I am often asked about student debt and how it relates to debt rule No. 1. When you incur student debt, in effect you are investing in yourself. And you are (hopefully) an appreciating asset! Most students’ net worth 20 years after graduation is higher than it was when they were in school. Therefore, student debt is a perfectly acceptable way of financing higher education, as long as you additionally follow rule No. 2.
Debt rule No. 2
The second rule: Do not borrow money before having a well-thought-out plan to pay it back.
This is where the biggest borrowing mistakes are made. When applying for a home mortgage, do you borrow the maximum amount the lender offers to provide you? Or instead do you first create a financial plan that includes expectations of income and expenses over the next 30 years?
By limiting the amount to be borrowed based on your anticipated ability to maintain the payments, you can avoid the likelihood of becoming house poor now and possibly having to sell the house in the future.
Borrowing for college also requires careful planning. How much student debt can you truly afford? Estimating the income you can get from a particular career, both initially and over time, can be valuable in determining the maximum debt to safely incur for your education.
For most everything else, if you have to borrow to buy it, then you probably can’t afford it. Consider a cheaper alternative for which you can pay cash.
Always remember that debt is not free money. You may face difficult times in your life when you have no choice other than to borrow money to stay alive. But for the most part, managing debt is simply about making realistic decisions about what you can and cannot afford. If you follow just these two principles, you will protect yourself from having debt overwhelm your lifestyle.