Some people make the mistake of solely blaming debt for their financial struggles—especially during the COVID-19 pandemic or the Great Recession. But debt—as ugly as your preconceived notions about it may be – is not always bad. The mistake is not always in borrowing; in fact, it often lies in the inability to use debt to your advantage.
Credit cards are a good example. Many people consider this bad debt because of the high-interest rates and the minimum payment requirements. While these two things can put you in debt for a long time, your own decisions can often render these debt characteristics harmless.
If you have the funds, you can always choose to pay more than the minimum of your billing statement. You can also decide to pay your balance in full to avoid the high-interest rate credit cards are so notorious for.
According to the Federal Reserve Bank of New York’s Household Debt and Credit report from Q4 of 2022, the average total debt per person stands at $59,580—a slight increase from $55,480 in 2021. This is an eye-popping amount. But it is also important to consider how your debt accounts play out and impact your financial plans. There are a few factors that can help you determine if what you owe will be good or bad for your finances.
The key to using debt with confidence is knowing and understanding how it can negatively impact your financial situation.
Dissecting debt characteristics that put your finances in peril
So, what are the characteristics you need to be wary of? Here are three common ones:
When the cost far outweighs the benefit
The first thing you should take into consideration is related to the cost. For example, when you borrow money to buy a house, you should only get as much as you need. Do not base it on the amount that the mortgage lender will approve.
For instance, the lender approved you for a $500,000 mortgage. Depending on where you live, this may allow you to purchase a 4-bedroom house. If only you, your spouse, and your two kids will be occupying the house – a 3-bedroom house is probably the best for your needs. Unless you can generate some income from that extra room – do not borrow the $500,000.
Borrow only what you need because the cost of the bigger space is not worth it if it will go unused. Plus, you’ll be paying more for maintenance and repairs. Remember that the fees associated with a mortgage loan are based on the percentage of what you will borrow. The higher the amount, the higher the fees and interest amount you will pay in the long run.
Another example is when you look at your student loans and weigh the cost against the benefit. There is nothing wrong with borrowing for college or post-graduate studies, but you should always take repayment into account. If your student loans are bigger than the income opportunities of your chosen career, they may not be worth borrowing.
When it keeps you in perpetual debt
When you take your finances seriously, you strive to reach a certain level of financial freedom or at the very least, flexibility. This can be a tough goal to achieve when you are kept in perpetual debt. You should learn how to use your financial obligations to your advantage and not the other way around. Being tied to your monthly payments can keep you from grabbing financial opportunities as they arise.
This does not mean you should eliminate all debt from your life—you just need to learn how to keep it from draining your wallet. For instance, you should pay attention to the fees and surcharges that can make your balance unnecessarily larger. Making only the minimum payment on your credit cards is another mistake you should avoid. Depending on your amount, it may take years—or even a lifetime—to completely pay off your balance. And you could pay hundreds or thousands more in interest.
When it keeps you from reaching long-term financial goals
Finally, you should be wary of debt that can hinder you from reaching your long-term financial goals. If you know it will keep you from maximizing your retirement contributions or building your reserve fund, you should strongly reconsider taking on the debt. Once you have reached your goal you can consider taking it on—but only if necessary.
Then again, if sacrificing one financial goal for another is your only option, then the debt can make sense. If you want to buy a house and you feel that it will make your monthly budget easier to manage, failing to maximize your retirement fund might be acceptable – but only for a limited period.
It is important to prioritize your goals. For instance, a home loan is okay but sacrificing your reserve fund is not a great idea. You should try to build up your emergency fund before proceeding with the home loan.
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Keeping in line to reach your financial goals
While you might know which debt characteristics to avoid, that does not necessarily mean you are in the clear. It is vital to continuously work on certain spending and saving habits that can help you improve your financial behavior.
Here are some tips that will help keep you in line even if you use debt while trying to reach your financial goals.
Make a budget and stick to it
The first thing you should do is create a budget and stick with it. Having a household budget can help you track both your income and expenses. It will be easier for you to ensure that your finances will be in line with your strategy for reaching your financial goals.
Make it a habit to read the fine print
To avoid compromising your finances, you should always thoroughly read the fine print before signing anything. While this is expected, not everyone does it. Many people skip this part because they may not understand it, or they find it tedious to read. This is a mistake that can end up costing you money in the long run. If you have trouble understanding the material, consider seeking help from a financial consultant.
Constantly improve your financial literacy
Finally, you should make it a priority to educate yourself about your finances. According to the Financial Industry Regulatory Authority, only about one-third of Americans have a firm grasp on understanding interest rates, mortgage rates, and financial risk.
There is nothing wrong with asking for an expert opinion – especially when it comes to major financial decisions. The fee you will pay could save you a lot of money if it helps you avoid costly mistakes.
Common questions about debt
How do I use debt to my advantage?
Debt can be used to finance an investment – like a house. A mortgage is considered good debt because it can help you increase your personal net worth. Just make sure any credit you borrow will help put money in your pocket, and not take money out of it.
How can debt affect my health?
Debt stress is a condition that can lead to all sorts of ailments. If you borrow too much money and you feel overwhelmed when thinking about how to pay it off, you could lose sleep and develop chronic conditions.
Which debt should be paid first?
Ideally, you want to pay off the high-interest debts because eliminating them could help you save money. However, there are debts that may cause the loss of collateral if you fail to send your payments (e.g. secured loans). These should be prioritized over unsecured loans – even if the latter charges higher interest.
Are debt resolution programs legitimate?
Yes, they are legitimate. There are a few ways you can reduce your debts. One is through debt settlement. Be sure to get in touch with a legitimate debt settlement company with a solid reputation that doesn’t charge upfront fees.
Another option is bankruptcy – which is also an option to help with the burden of debt. However, you should consider the impacts of these options before making any decisions.
Meeting your long-term goals, like purchasing a home, could require taking on debt. But before you do, be sure to see the big picture to understand your options and limitations.