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December 23, 2010

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There has been a generational change of view about using credit to buy a home.

If homes were still trending upwards in price, if the building of new homes was still at traditional levels, and if the unemployment rate was at normal levels, there would be very little discussion of the perils of using borrowed money to buy a declining asset.

It would also make a huge difference if America was not like a runaway train hurtling down a track and heading into a BUDGET DEFICIT and NATIONAL DEBT disaster that could have an incredible, hard to imagine effect upon its future.

This country needs to realize, just as other countries are realizing, that now is the time to face reality which means slashing government programs and raising taxes. Instead we have one party that will not raise taxes under any circumstances, and another party that will not slash government programs. Since America is really a collection of 50 united states the problems also need to be addressed at both state and federal levels. The reality is that in Washington it's still "Business As Usual", we don't want to be the bad guys, let's just pass the problems on to future politicians.

Meanwhile I don't blame anyone for not wanting to take on lots of long term debt. If I was a young 29 year old engineer with three children all under five, and the sole breadwinner, as I was in 1963, I would have stayed a renter if the economic and unemployment situation was as it is today. I would be building up my cash reserves in case I had to move my family across country to find a job. I was in the defense industry and there were periodic layoffs in between programs and with very little seniority I was pretty worried, which is why I busted my butt to get an advanced degree and to be the best employee I could possibly be.

Unless you are willing to buy a house in Detroit for $10k then having a mortgage is necessary evil but too much house that you can not afford is the evil part.

College borrowing only makes sense on degrees that will land you a job in that field of study. When you can't get that job using that "history degree" then what was the effort for?

If you total your car prior to having the necessary money saved and you really need that transportation then financing may be necessary. Financing the whole car is a problem. I have financed $4k on a $25k car but it was paid off in a year.

Unless you have to replace the sewer conncection from you house to the street to the tune of $5k to $10k then I would deem that as an emergency that most people can not plan for.

No comment on growing a business.

I agree with growing a business. The company I work for needed a better way to make a widget and they took out a major loan along with opening the door to investors to improve and expand their facilities. In 2 years they have multiplied their quarterly revenue by a factor of 30(that's x30 not 30%).

I understand the desire to reduce one's debt, but why would I want to pay cash for a car vs. putting that capital to use elsewhere. With all the zero percent interest options on new cars, and even low interest on used cars (for example, Pen Fed Credit Union is 2.99%), I would much rather put my cash to work elsewhere. A lower risk corp or govt bond fund would offer greater returns, and the odds of a significant decrease in your investment are low enough. Even if it did go down, you would have months or years to replace it. It seems the potential benefits outweigh the additional risk.

Anyway, to me this is very relevant as I consider replacing my 14 year old car with 223,000 miles on it. I could pay cash for one of the vehicles I'm considering, but even with all the events of the last 2-3 years, my returns exceed the interest rates being offered to me. My approach has been to make monthly car "payments" to a separate sharebuilder account for this purpose.

I could make the same argument for mortgages, though it seems a potential first time home buyer, a category I fall into, would be hard pressed to pay cash upfront.

I agree with Chris. Not just on cars, but on homes or other investments as well. If you can use the bank's money (in the form of a home loan or car loan) at 5% to earn 10%, 15% or 20% on a different investment, why would you want to pay down that debt quickly?

My wife and I just put 20% down to buy a rental house. The bank is allowed to lend to us on up to 3 more properties before a federal cap kicks in. We have no interest in paying down that first mortgage (which would guarantee us a 5% return on our money) when instead we are close to having a second down payment for a second rental property which should produce a return of 10% minimum but as high as 25% or more over time with reasonable appreciation.

By the same token, I could pay off the last 10 payments of my car loan as well as all of my student loans in cash right now, but it would earn me less than a 5% return. It would be almost like throwing money away, in my opinion.

Jonathan, Chris, and the rest of you "why pay it off" people --

There's a difference between theory and reality -- what could happen and what usually does happen. Perhaps you're in the minority who will not suffer a job loss, no renters, and other economic issues that are aggravated by having debt. Perhaps you are in the minority who can actually earn more on your money than what you pay in debt (not many can/do, you know.) Perhaps you are in the minority of those who will actually save/invest instead of blowing the money they don't use to pay off debt. But most people are not better off IMO by keeping debt because they can't do/avoid those things.

And just to be clear, you don't have to make yourself cash poor to pay off debt -- even your mortgage. If you follow my advice on how to buy a home, how to grow your career, and how to maximize the gap between what you make and what you spend, you'll have plenty to sock away as well as pay off your debt.

In addition, there are some very nice intangible benefits associated with being completely debt free -- namely a sense of freedom. Believe me, I know. But if you've never been completely debt free (as an adult), you really can't relate to it.

I agree with your five caveats, FMF. The only one where I might be a bit more lax is the one re building a business. Re that one, I think it depends on the circumstances, I don't think there is one good rule.

Rob

I understand what your saying and do agree with some. Home, business, I can see that. Education only if you have to pay for it yourself and the market shows your education will pay you back in years to come. If consumers would just live within their means, get rid of all credit card debt, and save for the extras they want in life I believe they would find a much happier and less stressful life really does exist.

FMF, you're right, I'm sure that for many people, the 'get debt free and stay that way' is the best advice you can give. I do find myself fortunate enough to be in that minority of people who can save and invest and not blow the money, and I know many people older and wiser than myself who have made fortunes investing (primarily in real estate). They have lots of debt, but far more in assets and very strong cash flow. Debt really is a tool which, when used properly, can open very large doors.

@FMF

Why does a car loan make not sense?

I am paying 1.9% for 5 years on car loan.

I can earn better than that in Rewards checking, but even if I couldn't, my home loan is much higher at 5.25%, which even after taking deductions into consideration, is still higher than the car loan.

It would make more sense to put 15k into the house and take the lower car loan...no?

TJ --

There are exceptions to almost every financial "rule." Do you think most people are paying 1.9% on their car loans?

I thought that loans were dirt cheap these days!

If someone had the cash to afford to buy a car outright, I assume that their credit is good enough to get a good loan rate, but its certainly possible that that is not the case.

I like to save up instead, but that might be just me ;)

Here's a cynical view on the car issue: If somebody is offering an APR well below the market price, a buyer could probably negotiate the cash price cheaper, since the seller is making the money back from the cheap loan by making more on the car. If a buyer can earn significantly more than the APR on a market-price loan, there's probably a lot more risk involved too. Which may be worth it, or may not. So I guess I'm kind of in agreement with those who say a car loan isn't a good idea if there's any chance you could pay cash.

in my case - I negotiated the price through internet - before I even walked in the door. I had a pre-approved loan from Penfed for 2.99%, that I planned on using, but they were able to beat it.

I think that borrowing for these 5 items can make sense at least in some situations. Home loans are hard to avoid. College loans can be useful if the situation is right. Car loans are OK to me at least when you are first starting out. I don't expect a 22 year old to have a pile of cash to buy a car. But later in life buying cars with cash should be an easier goal. Business borrowing really depends on the situation. It can make a lot of sense or it can be foolish. Sometimes you really do need money to grow and prudent borrowing can be the quickest way to get there. But businesses can also borrow themselves into bankruptcy.

REal estate investing is like a business. It can make sense to borrow to invest in property. But you have to make the right choices and know what you're doing and theres risk. Dave Ramsey went bankrupt in real estate if I recall right.

I think that avoiding debt is a good overall goal. But sometimes debt is 'ok'.

I would not borrow money for the specific purpose of investing with the hope of high returns. But I also wouldn't pay off a low interest mortgage early while skimping on retirement savings.

I know that for most people, the 'get free of debt and turn into that way' is the greatest advice you are able to give. I actually do find myself lucky enough to maintain that minority of people that can help to save and invest and never blow the cash, and that i know lots of people older and wiser than myself who've made fortunes investing (primarily in tangible estate). They've plenty of debt, but much more in assets and incredibly strong income. Debt is indeed a tool which, when used properly, can open large doors.

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