BlogUnderstanding Debt

What are the key situations when going into debt is worth it?

By September 6, 2021 July 29th, 2022 No Comments

David A. Dubofsky

Retired Professor of Finance – University of Louisville and author of “Your Total Wealth…. The Heart and Soul of Financial Literacy”

What are the key situations when going into debt is worth it?

Personally, I view debt as a drug. If you use drugs irresponsibly, you will suffer the consequences. The same holds if you use debt irresponsibly.

But that said, drugs are appropriate in some circumstances, as is debt.

  1. Debt is appropriate when buying your residence/home. You must live somewhere. Either you pay rent, and get nothing back in return, or you buy a house and part of your monthly mortgage payment becomes equity. You get your equity back when you sell your house. Homes, along with stocks, are the two major sources of individuals’ net worth. Homeownership builds financial wealth. Also, in some cases, you may be able to deduct the interest and real estate taxes you pay on your monthly mortgage payments. But heed some key warnings before you run out and buy a house: First, you should have enough saved to make a 20% down payment on the house. Second, your total monthly payment (interest, principal, real estate taxes, insurance, and regular maintenance) should not be much more than the rent (and renter’s insurance) you would otherwise be paying. I say it can be a bit more because you are building equity in your house and the interest and real estate taxes may be deductible. Also, rental payments can increase significantly over time, so owning your own home lets you avoid that rent increase. Hence, there is nothing wrong if your monthly payments are a few hundred dollars more than your alternative rental payments. But avoid becoming “house-poor,” the situation that exists when you are pouring money into your mortgage payments and do not have enough to live comfortably beyond that.
  2. Debt is often appropriate when buying your car. You need to have personal transportation. How are you going to get from here to there? If you need a car, taking out a low-interest rate loan to buy the car you need can be appropriate. A key warning: buy your car for transportation and nothing more. Do not overspend buying an expensive car because it is a status symbol or makes you feel good. It is necessary transportation you are buying and nothing more. Buy dependable cars that do not depreciate rapidly and have good resale markets.
  3. Debt can be appropriate when you know you will need something and know you will have to buy it soon, but the item is on sale today. So, suppose you are certain you will need a new suit in the next few months, and you see the perfect suit today that is on sale for 50% off? I think it is OK to borrow today to acquire the suit at 50% of its regular price, rather than wait a few months to buy a suit for twice the price. But you have to ask yourself: Is this something I really need and will have to buy it sometime soon?
  4. Debt can be used to fund productive projects that are very likely to provide a rate of return higher than the interest rate you are paying. The key phrase here is “very likely.” The borrower must have an unbiased and accurate view of what the project’s rate of return will be. Borrowing to pay for an education is only advisable when you can be reasonably sure that you will earn a higher wage after you graduate. Borrowing to fund a business is appropriate when you are reasonably sure that the business will be sufficiently profitable to repay your loan. Just do not get overwhelmed with excessive optimism when evaluating your payoffs. A recent WSJ article points out that many graduate degrees from elite universities do not lead to post-graduation salaries that can repay the loans used to pay for the education, so do your homework before you borrow to go to a university.

Debt is never appropriate for expensive vacations or entertainment. Do not carry expensive credit card debt with double-digit interest rates. Pay off your monthly credit card bills immediately if the interest rate you are paying is high. Nowadays, anything over 10% is too high. Compare the interest rate on your credit cards to the 3% or 4% you might pay on a mortgage or auto loan.

David A. Dubofsky

Author David A. Dubofsky

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