The following is a guest post by Dan Wesley at Credit Loan. After Dan's thoughts, I've detailed where I agree and disagree with him.
The Credit Card Act made it easier to see what kinds of fees your credit card company is charging, and that’s a good thing. But with the average American household having $15,788 in credit card debt, better notification requirements still don’t make a credit card bill worth looking forward to getting when the mail arrives.
While we recommend having no debt, that’s not realistic for many people. If managed well, some debt is OK. If it’s an investment in your future, it’s good debt. Here are five times we think debt is acceptable:
1. Home loan
Good debt includes anything you need but don’t have the money to pay for it upfront, including liquidating investments to pay for it. Long-term debt, such as a bank loan to buy a home, is one of the most obvious ways that debt can be a good way to pay for something that you can’t afford immediately. Who has $300,000 in cash sitting around?
A large down-payment is a good idea to keep your monthly loan payments down. Mortgages usually have lower interest rates than other debt, so you don’t want to put all of your cash reserves into a down payment.
There are also tax advantages to owning a home. The federal home buyer credit has expired, but mortgage interest, property taxes and other expenses are deductible from taxes for homeowners.
Borrowing from a 401(k) retirement plan or taking out a loan on your home is a bad idea to pay for a child’s college education. Your children have many more years of earning potential than you do, and giving up part of your retirement fund or possibly losing your house if you default on a college loan is no way to go into more debt.
But your kids can take out government-backed college loans at low rates, and payments aren’t due until after graduation. Of course a better way is for them to work and save their money to pay for college so they won’t have to go into debt, but that’s another tale.
Like a home loan, a car is something not many people can afford to pay cash for and buy outright. Putting down as much money as you can afford is a good place to start. The goal should be to drive the car as long as you can after the loan payments have stopped.
Just make sure to shop around for the best interest rate on a car loan -- your bank and credit union might be able to beat a car dealer’s loan rate. Don’t be fooled by a low monthly price; be sure to look at the overall cost of the car when the loan is paid off.
If you pay your credit card bill off every month and don’t use it much, an emergency is a good time to use a credit card. Just try to pay it off before the next billing period. Things happen in life -- a car accident, hospital visit, car breakdown, broken tooth -- and not having the cash in hand can lead to more hardships if you don’t get the problem fixed soon. Not having a car for awhile could lead to losing your job if you depend on your car for work.
Granted, having an emergency cash fund for such instances is ideal, and is something you should build in preparation for such events. But even with money in the bank, a credit card may be the fastest and easiest way to make an emergency payment. Just don’t let that debt stay on your balance sheet for long. An emergency fund will be a lot easier to fund than paying off a credit card bill.
5. Growing a business
Notice that we didn’t say “starting a business.” If that’s what you want to do, talk it over with your banker, since starting a business can be a risky proposition. Many businesses can be started cheaply -- $1,000 or less -- with a website to gauge interest.
Once your business is going and successfully making money, then it might be time to take out a loan to expand. Businesses can hit plateaus and can’t grow without more facilities or ways to make a widget, and a loan can jumpstart things.
Here's my take on these:
1. I think it's ok to take out a loan to buy a home, but only if you use my formula for buying a home, which will have you mortgage free in 7-10 years. For those of you who don't know, I paid off my mortgage approximately 13 years ago.
2. I think it's ok to borrow for college as long as you do it the right way. I had $5,000 in student loans after I got my MBA, but the investment was well worth it. That said, there are ways to go to college debt free if you really want to work at it.
3. No way on the car loan. Save up and pay cash.
4. An emergency fund should cover all but the most severe emergencies. However I'm ok with using a credit card for an emergency -- as long as it's paid off before any interest accrues.
5. I'm not sure about the "growing a business" suggestion. If I was fairly confident of a good return, then I might borrow a modest amount -- as long as I thought I could pay it off quickly. If it was risky and there was no way I could pay it off in a reasonable amount of time, then I wouldn't borrow.
How about you? What's your take on these five times when it "makes sense" to borrow?