It’s nice to have a healthy bank balance and no debt. But few of us would own homes or even cars if we didn’t borrow sometimes. Financial experts frequently speak of “good” debt and “bad” debt. Yes, sometimes debt can be good. Here’s how to know when personal loans are a good choice, and the best uses for personal loans.
What is “good” debt?
“Good” debt means different things to different people. Some say you should only take on debt for investments that will return more than they cost, including the financing. Examples include financing an education, purchasing a home, buying or starting a business or acquiring a car to get to work.
But it’s not always so cut-and-dried. There is a difference between the sensible commuter car and the costly Ferrari. The wrong house in the wrong neighborhood can lose value. And the news today is full of cautionary tales about luckless college students graduating with six figures of debt and unable to get jobs in their field.
Are short-term purchases always “bad?”
Conversely, some might say that using a personal loan for a trip, a wedding or a boat is a bad use of good money. But what if you won’t be able to take that trip in the future because you’re starting a family? Or have health problems? What if you have a huge family and including all of your cousins in your wedding means everything to you? What if that boat fulfills your dream of seeing the world?
When personal loans are a good choice depends on many factors.
How to tell if a debt is good or bad
Before you evaluate the question of financing, ask the question about acquiring.
- Does it fulfill a basic need, like shelter or transportation?
- Can it potentially increase your net worth (an investment, business or education)?
- Is it very, very important to you?
- Will your daily quality of life suffer now and in the future if you don’t finance this purchase?
- Is there a compelling reason that you can’t put off the purchase until you save enough to pay cash?
- Is there a less-expensive way you can achieve the same goal, or a way to avoid debt?
Imagine not only the purchase but the next years after. So contemplate your life a year after your wedding. If the party’s over, but you can’t buy a house, travel or replace your old car because you’re still paying off the caterer, you might want to scale back a bit. But if you see yourself debt-free in a year and ready to start the next chapter in your life together, the big bash may be worth throwing.
A recent study published in the journal Psychological Science found spending money actually did give people happiness. As long as what they bought matched their personality. So if you know yourself very well and exactly what will bring you joy, far be it for this writer or any other expert to tell you how to spend. It’s a very personal decision.
So, “good debt” is financing used to buy things that make sense for you. Here’s a look at some decisions you might face as a consumer.
Before taking on student debt, determine what a degree in your field from your chosen institution is worth. The US Bureau of Labor Statistics (BLS) can tell you what entry and top-level jobs in your profession pay, and if their demand is growing or shrinking. And before borrowing privately, investigate scholarships, help from your employer and low-interest loans or grants.
Need a car for work? It doesn’t have to be new or inspire envy in your frenemies. Find a reasonably priced auto with a reputation for reliability. If you “need” a car for recreation or self-expression, that should come out of your recreation budget as well as your basic budget. Calculate what the fun will cost and decide how you’re going to pay for it before you buy. It’s a documented fact that the thrill of such purchases usually wears off long before the term of an average car loan — be aware.
Want to buy a house? You’ll probably need a mortgage. But not everyone is ready for one. Calculate what your mortgage, property taxes, homeowners insurance and maintenance would be for the place you want. Subtract your current rent from this and put the difference into savings each month and see how it feels. If you’re comfortable with less disposable cash, you might be ready to buy. And now you’ll have more money to make it happen.
How about starting a business? Even if you have the cash to get started, it can be smart to line up personal loans and lines of credit in case of financial hiccups. But don’t buy or start a business without a lot of research. Business lenders want to see business plans and know that you are capable of running your enterprise successfully. Hire a finance and accounting team to help you out unless you are very, very good at financial management.
Even items that seem frivolous can be good debt, if you choose the right ones and go into debt with eyes open. If you want to take a luxury cruise, for instance, it might take you a year, saving $1,000 a month, to cover the $12,000 price tag. But many lines offer sales prices to those who book and pay a year early. Two-for-one deals are common, and some even throw in airfare, drinks packages or internet as incentives. If you have to pay 10% in personal loan interest to save 50% on your purchase, it can make sense to finance (monthly payments for a year at 10% on a $6,000 purchase are just $528 — a lot less than $1,000).
It’s almost never a good idea, however, to finance a short-term luxury over a long time. You don’t want to skip vacations for the next five years because you’re still paying for the last one. Expectations adjust a lot more easily than loan balances.
Why use a personal loan?
The second factor that determines if a debt is good or bad is the loan itself. The worse the terms of the financing, the worse the debt. Even a worthy expenditure can be foolhardy if you finance it poorly.
Suppose you need a car. But you don’t need a new car. You don’t need a Ferrari. And you don’t need to pay for dealer financing if it’s not a great deal. You need some furniture so you’re not eating and sleeping on the floor. But you don’t need a houseful of new stuff on a credit card with a 36% interest rate.
Personal loans can be used to finance just about anything, however smart or dumb it may be. And there are several reasons that a personal loan might be the best way to purchase things on credit:
- Personal loans have lower interest rates (on average, about 7% lower than credit cards)
- Most personal loans have fixed interest rates and payments, so budgeting is easier
- Personal loans have fixed terms, so you have a definite payoff date
- Personal loans can’t be run up repeatedly like credit cards
In short, if you have any doubts about your ability to discipline your spending, consider a personal loan. And get yourself to a reputable non-profit credit counselor.
Personal loans are less likely to get you into trouble. You won’t be making minimum payments for 20 years with a personal loan. Your payments won’t skyrocket (as long as your rate is fixed). And you can’t run personal loan balances up again after paying them off.
In fact, one of the best uses for a personal loan is to pay off credit card balances (assuming you stop overspending). Because carrying credit card balances month after month is one thing that we can all agree is bad debt.