Debt per se is not bad, and it’s not evil either. Debt, any kind of debt, including credit card debt, is a tool; and just like any tool must be used according to its purpose.
When it comes to personal finances, you must run your household like a company, with the same principles and strategies of corporate finances.
Those of you who went to business school and didn’t fall asleep during Corporate Finance 101, might remember the principle which states that assets should be financed for the same length of time as the duration of the asset itself.
In plain English, there are two components to effective debt strategy:
- Only finance assets, actual tangible things that last longer than one year, and that are productive,
- The length of the loan should match the life of the asset.
Therefore monthly expenses like rent, mortgage, grocery don’t qualify because they fail the test of duration. And things like jewelry, vacations and large screen TV don’t qualify either.
What does qualify are: a house as a mean to secure a place where to live, not as a mean of investment or speculation; a car as a mean of transportation, tools that you need for your job or business, and few other major expenses.
For everything else, there’s a long forgotten principle: it’s called saving for rainy days.
So if you are buying a house, unless you have special circumstances where you are sure to have your income and cash flow increase in the future, the safe principle is: 20% down payment, and a 30 year fixed rate mortgage, with a payment that you can afford. Should the interest rate decline by 1% or more, refinance with a new mortgage that has the same duration as the remaining time left on your mortgage, and it’s also a good idea to continue paying the same (higher) payment that you are used to in order to eventually pay off your mortgage. Having a house fully paid is the #1 step in retirement planning (that’s another topic).
If you are buying a car, a 5 year loan is usually a safe bet for a brand-new car. If you are buying a good used car, a 3 year loan is usually appropriate.
Student loans are a separate case, educations is the greatest asset that anyone could have, so student loans to finance one’s education is indeed one of the best investment anyone could make. Of course while in college, it’s a good idea to stay away from credit, and – if your courseload and time allows you – to pick up a part time job to take care of everyday expenses.
Debt is not bad, bad use of debt is bad. Debt is a tool, that when used correctly can make a difference in overall quality of lifestyle.
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