Financial Success

Christian:  Hi Laurie, I’m so glad we’re continuing our conversation. I really appreciate your taking the time to share your perspectives. Our prior chat addressed saving, so I guess on the flip side…I’ve been wondering, how will I know when it is appropriate to take on debt?

Laurie:  In short, Christian, some forms of debt are more beneficial than others. An affordable mortgage or a student loan can be considered “good” debt, whereas credit card debt is usually “bad” debt. It’s important to understand the difference between good and bad debt because at some point in your life, most likely while you’re young, you may find that borrowing is your only option to fund a major purchase or investment. (For more, see: Paying Down Debt vs. Investing.)

Debt can be useful for financing large investments like a home or a college education. Although one is a physical property and the other an intangible idea, I think of both as investments because you will extract value from them in the future. Since both of these investments are high cost, it makes sense for individuals with a low net worth to finance these purchases through debt.

In addition, the interest paid on student loans and a mortgage can both be tax deductible, whereas the interest on credit card debt is not. Mortgage interest can almost always be entirely deducted, while student loan interest can be deducted up to $2,500 a year.

Debt taken on to purchase a vehicle falls somewhere in the middle ground. While financing a car purchase is sensible for some, the decision should ultimately depend on the specifics of the deal you are interested as well as your credit score. Although it may be easiest to go through the car manufacturer’s financing department, that’s not always the best solution. With auto loans – and really in any borrowing situation – it’s best to shop around and check out local banks or credit unions to fully exploring your loan options. Be smart, but be sure you don’t shop around too long because prolonged periods of credit inquiries can lower your credit score. (For related reading, see: Student Loan Debt: What Every Borrower Should Know.)

Christian: If credit card debt isn’t “good” debt, why do so many people use credit cards? Is the interest that accrues really that high?

Laurie: Well, many people use credit cards because they are convenient. However, many credit card users are unaware of the hidden dangers such a convenience poses. If you don’t have the funds to back up the purchases you’ve made, you might find yourself in trouble. But there is still a responsible way to use a credit card. If you use it to buy your groceries, maybe gas and sometimes fund a night out, but ensure that you pay off your full balance as soon as you receive your monthly bill, you will avoid potentially high interest payments on your credit card debt.

Unfortunately, it’s easy for less responsible people to view credit cards as a type of personal lender. Say you want to buy a new smart TV, but don’t have the cash on hand so you charge it to your credit card and plan to pay it off over the next few paychecks. Your paycheck comes the next week, but on payday you accidentally rear-end someone. Now you have to pay for the car repair or an insurance deductible, so the balance on the card for the TV carries over to the next month. Credit cards profit the most when you use your card this way, since they use your previous month’s unpaid balance and your current month’s purchases to calculate your interest. (For more, see: How to Use Your Credit and Debit Card Safely.)

So now not only do you have to pay back the balance and interest from the original balance, you will now also have to pay interest on the interest from last period. This wouldn’t be much of an issue if the rate were 1%, but usually interest rates on credit cards are much higher – often 20-30%.

We recommend that you use your credit card to make affordable purchases and then pay off your balance each month to avoid the exorbitant cost of carrying an unpaid balance. The steep interest charges can quickly make your debt unaffordable. (For more, see: How to Budget and Spend to Maximize Your Happiness.)

Christian: That’s shocking, I didn’t know that could be the case. This is something I will definitely keep in mind. I’m also wondering, do you have any thoughts on how to obtain the best possible mortgage?

Laurie: Your ability to obtain the best possible mortgage and lowest interest rate in general is heavily affected by your FICO or credit score. There are many ways to either build good credit or improve upon your current credit score. It’s important to know however that building or improving a credit score will take time. The easiest way to start building good credit is to always pay your bills on time, pay off credit card balances monthly and avoid carrying over balances into the next period. Keeping a low balance on your cards (somewhere around 25% or less of your credit limit) can also help to build good credit.

It is also important to avoid opening extraneous credit card accounts. The last big component of your FICO score is your credit history. Older adults are more likely to have had major credit events take place, such as a possible mortgage foreclosure during the 2008-09 global financial crisis. For young individuals like yourself, there isn’t much history to even look at, so you may instead want to look towards building your credit history. If you use your credit card responsibly, refrain from opening too many credit cards and pay your bills and balances promptly, you will be well on your way to establishing excellent credit that will help you qualify for the best rates on future loans.