While many financial gurus advocate for avoiding debt altogether, we recognize that some kinds of debt are advantageous because they help build wealth. However, even the wealth-building kinds of debt can place too heavy a burden on your finances if you take on too much at once.
Before taking on a new debt, you should ask yourself two questions:
1) Will this debt help me advance my wealth or financial goals over time?
To help you answer this question, here are some examples of debts that, if used wisely, can increase wealth over time:
- Mortgage: Buying a home is a great way to build wealth, especially if you plan to stay in the home for more than five years. Mortgages allow homeowners to build equity as they pay down the principal over time, which is compounded by the current upwardly trending 6.8% annual market appreciation on home values.1
- Home equity loan: The best reason for obtaining a Home Equity Loan or Home Equity Line of Credit (HELOC) is if you are using the loan to make equity-enhancing improvements to your home. The interest is deductible only if the loan is used for home improvement purchases. However, some use these loans to consolidate or pay off high-interest credit cards or loans. While this tactic does not build equity, it can help you get in control of high-interest debt so more of your budget is available to put towards savings.
- Student loan: While student loans may sound like a scary prospect, they can be a great investment if the loan will be going towards a degree that has high-income career prospects. Generally, degrees in the STEM fields have better career prospects than degrees in the Liberal Arts.2
- Small business loan: This is the riskiest type of good debt, but if you start a small business with a loan and achieve success, it can also have the biggest payoff.
The following types of debts are likely detrimental to your wealth over time:
- Car loan: The best way to purchase a car is to pay in cash. However, for many Americans, paying in cash is an impossibility, and a car is often a necessity for their jobs. If you find that you need to take out a loan to buy a car, we recommend that you a) buy a used car and b) find a loan with a zero or very low interest rate, and pay off the loan as quickly as you can. It is best to pay as little interest as possible on a car purchase because the depreciation rate is so high.
- Consumer finance loan: The only time it is suitable to take a loan out to purchase new furniture, a new appliance, or any other major household purchase is if the loan has a guaranteed zero percent interest rate for the duration of the term. High interest consumer debt should be avoided at all costs.
- Credit cards: While many utilize their credit cards to take advantage of the rewards – airline points, cash-back, and other benefits – if your credit card isn’t being paid in full each month, then the rewards are not worth the interest you pay on your outstanding balance.
2) Will adding this debt to my monthly expenses put too much strain on my budget?
Even if the loans you have acquired fall under our list of beneficial types of debt, these loans can become detrimental to your financial health if you have borrowed too much. One way to determine if you can afford a new loan or if your current debt is manageable is to look at your debt-to-income ratio:
Debt-to-income ratio = Total of all monthly debt payments ÷ Gross monthly income
In most cases, in order to obtain a “qualified mortgage,” borrowers need to have a debt-to-income ratio of lower than 43%.3 However, the lower your ratio, the better, not only for obtaining better rates on new loans, but also for your ability to maintain on-time, in-full monthly payments.
If you are worried about high-interest debt or your current debt-to-income ratio, one action you should consider taking is refinancing your home mortgage. Mortgage interest rates continue to be offered at historically low rates, and a cash-out refinance or Home Equity Loan are both ways to consolidate high interest debt into a lower rate loan. If you would like to discuss your options further or be referred to trusted mortgage lenders, call your FinPlans team at 317-882-7675.