Handling Debt

Debt is to be handled extremely carefully. A little wisely used debt can expand your life substantially. A lot can utterly destroy it. Beware that decisions about debt aren’t solely made on the amount of debt. The purpose, conditions, duration, and situation surrounding the debt are all factors in the decision to use debt.

Begin by considering how debt functions. The mechanics of debt are the exact opposite of long-term investments. While investment returns compound your original principal, debt compounds the amount you will pay others. Interest slowly drains your wealth before you ever begin to return the original principal. If you don’t repay loans in a reasonable frequency, the total amount owed grows larger. Decreasing each payment only allows your interest to build, increasing the total amount of debt, and the amount of times you pay the debt. Remember before you borrow money: you could be investing the original principal and total interest on debts you owe.

Debt Consumption Decisions

Due to interest, you should be absolutely sure you need an item before you acquire it with debt. If you can comfortably afford it without debt, there’s very little reason to acquire a loan. Debt should only be used in absolutely essential situations. Most people use debt willingly for consumer purchases. You should avoid this, especially if the item purchased will depreciate in value. You should always attempt to buy in cash. Debt is worthwhile if it’s used for emergencies and purchases which will appreciate in value or increase your earning power. Almost all consumer purchases don’t meet that standard.

Quite often, the interest rate eliminates the option of debt. The higher the interest rate of the debt, the faster the debt will accumulate the total amount owed. This also reduces the chances your debt will be used to purchase items that are worthwhile. If a purchase increases in value over time using debt to acquire it can be wise, especially if the rate of value increase exceeds the rate of interest on the debt. The higher the rate of interest, the less likely this is to occur. A depreciating item’s value will steadily move further below from the cost of debt unless the total amount owed is paid off faster than depreciation. The higher your interest rate, the faster this separation occurs, and the more you’ll have to pay to avoid owing more than the item’s falling value. If you must borrow to purchase something, compare the interest rates and select one the lowest fixed rate possible. That way you’ll know what you’re paying in advance.

Many people who use debt don’t consider the full extent of the impact. Your overall liabilities increase and debt creates a cash outflow every month from each payment. If the interest rate is high, the overall liabilities will grow faster. If the interest rate is variable the monthly cash outflow can increase at any moment, depending on the interest rate’s benchmark. The cash required to pay debt off will grow faster as well. These are the questions you should ask yourself: Can I handle the outflow of money created by this debt both immediately and in the long term? Is this item worth that outflow? Am I comfortable increasing my liabilities by the value of this debt to purchase this? Will this item appreciate in value and offset the loan’s cost? Will this item increase my monthly income by more than the cash outflow created long term? Most or all of these questions should be yes when considering debt.

“Good” Debt

The value of the item purchased with debt also affects the categorization of debt. If an item bought with debt increases in value after purchase, increases income long term, or delivers a return greater than the interest cost, this is referred to as good debt. This debt is being used to increase your wealth over the long term beyond the cost of the debt. That’s positive. A conditional should be given: good debt is only truly good when the appreciation of the item purchased and the rate of debt repayment exceeds the rate of interest on the debt. Bad debt, on the other hand, is debt used to purchase goods that depreciate in value over time. These usually involve consumer goods that rapidly, or instantly, lose value. While purchasing goods that rapidly depreciate is never wise, it is especially unwise to purchase them with debt.

Debt and Retirement Accounts

The last common mishandling of debt is borrowing from or against your retirement accounts. It’s especially bad if you will be charged interest until you repay the money removed from the retirement fund. Most retirement accounts have a taxation penalty on “early withdrawals”. In the United States, You’ll trigger the penalty by withdrawing money from a retirement fund if you’re under 59 years of age. This penalty is typically 10% on top of the normal income tax rate. If your tax bracket was 35% income tax, you could wind up paying a 45% tax on that money.

If you owe money outside of a retirement or investment account, it’s foolish to sell investments to pay down those debts. Don’t sell appreciating investments to purchase depreciating goods. The higher the rate of return on the investment, the more future income you’re losing to pay down interest costs potentially lower than those returns. You may also trigger capital gains taxes by selling assets for cash, costing you even more money.