Is All Debt Bad?

 

If you're an American adult, chances are you have some sort of debt. As a nation, we had $2.46 trillion of debt as of June 2007. And that doesn't include mortgages. That's an average of $8,200 of car loans, student loans, credit cards, and other personal loans for each and every one of us (including newborn babies).

Looking at those statistics, you might assume that debt is either very good (since we have so much of it), or very bad (for the same reason). The truth is, it's neither.

Debt is a tool. It's unavoidable for most people-especially homeowners, college students, and entrepreneurs. Depending on how it's used, debt can be an investment. For example, the average college student graduates with about $20,000 in loans, but will make about $900,000 more than the average high-school graduate over the course of her career.

The biggest questions are, "What opportunities does this debt offer me, and what are the risks?" 

Let's look at a few common situations:

A New Kitchen

Ada and Leon are dying to renovate their kitchen, and it will cost about $20,000. They’re thinking of using their home equity line of credit (HELOC) to fund the project.

Good Idea?
As long as they can afford the loan payments, Ada and Leon are making a really smart choice. The interest on their HELOC is probably lower than their credit cards or a personal loan, and it’s tax-deductible. The kitchen updates will raise the value of their home and make life more comfortable. Plus, this is exactly what a HELOC is meant for.

The Emergency Credit Card

Lara had planned to stick to her shopping list ... until she came across the clearance sale at her favorite boutique. She splurges on a few outfits, but knows her checking account balance won’t cover the total. Instead, she pulls out her emergency credit card.

Good Idea?
Lara might have gotten a great deal on her new clothes, but we all know a sale doesn’t count as an emergency. If she doesn’t have the extra cash to cover her purchase now, there’s a good chance she won’t have it next month either. This one time probably won’t do too much harm, but hopefully Lara isn’t in the habit of spending money she doesn’t have.

Getting Out of Debt

 

Gordon's been in debt for most of his adult life. He's cleaning up his finances now, and wants to pay as little interest as possible until he gets his final debts paid off. He's thinking of using his HELOC to pay off three credit cards and his high-interest car loan.

Good Idea?
By the numbers, Gordon's making a smart choice—especially if consolidating helps him to pay off his debt faster. He needs to remember that his house is the collateral for his HELOC. So if he can’t make the loan payments, he could lose his home in foreclosure. He's used to those debt payments coming out of his monthly budget, so as long as he doesn’t run up new charges on his credit cards, he should be just fine—and soon debt-free.

Make This Work for You The next time you're thinking about taking on new debt, answer these questions first:  How much interest will you pay overall? (See our calculator for help with this.)  Will taking on this debt help you earn extra money?  Have you found the best deal possible on the loan, credit card, or line of credit?  How would you accomplish this goal if this credit wasn't available to you?

16AFS