5 Times When it Makes Sense to Borrow Money

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.

2. College

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.

3. Auto

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.

4. Emergencies

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.

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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?

Comments

[Old Limey]

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.

[Matt]

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.

[Jeff]

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%).

[Chris]

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.

[Jonathan]

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.

[FMF]

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.

[Rob Bennett]

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

[Mike]

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.

[Jonathan]

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.

[TJ]

@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?

[FMF]

TJ --

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

[TJ]

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.

[Eric]

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

[Pete L]

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.

[TJ]

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.

[jim]

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.

[Jnifer]

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.