Forget debt-free living: Here’s when having debt is a smart move
Lots of finance experts are firmly on the "Debit is evil!" bandwagon -- and with good reason in some cases. There are countless tales of woe from folks who struggle to pay off large or growing debt.
But some of those advisors may be a bit shortsighted on the topic of debt. Luckily, for every anti-debt extremist, there's another finance expert who understands that debt is not inherently evil.
As with most things in life, the truth behind debt is more gray than it is black and white. And there are a number of instances in which debt can actually be a good thing. Here's what they are.
When the alternative is worse
The main reason most of us take on debt is because the alternative makes the potential downsides worth the risk. If taking on debt is the only way to get certain necessities, then it can be worthwhile.
For example, if your choices are to take out an auto loan or to lose your job because you can't commute, then the debt of that auto loan makes sense. Sure, it's going to cost you some money in the long run -- interest charges add up, even on low-interest loans -- but it's worth it for the ability to get to where you need to go and keep your job.
However, the key here is to assess whether you're considering a loan for something you want or something you need. Taking on debt to get a critical method of transportation is probably smart, while going into debt to upgrade your entertainment system is probably not necessary.
When the interest rate is negligible
Another time when taking on debt might be a smart move is when that debt doesn't actually come with much -- or any -- cost. That's because it isn't the debt itself that's usually the problem (meaning, the original amount you borrowed). No, in most cases, it's the interest charges that make debts hard to pay off.
However, if you can avoid those expensive interest costs, then debt often becomes significantly more manageable. The most common way to avoid interest on debt is by using credit cards with 0% APR offers. These cards have introductory or short-term promotions where you pay no interest for a set period of time.
When you make purchases on a card with an active 0% APR offer, you can carry a balance from month to month without accruing interest charges. While you'll still need to make at least your minimum required payment on time every month, these deals can give you six months or more to pay off your purchase without worrying about interest charges.
When the opportunity cost makes sense
One common method used to make financial decisions is to examine the opportunity cost. Basically, opportunity cost describes the opportunities you give up when you use your money for something else. For example, when you head into a store with $20, if you spend that $20 on a few magazines, you give up the opportunity to spend that money on a bottle of wine and a frozen pizza.
When it comes to getting a loan, sometimes taking on debt -- even with the included interest -- makes more sense than using cash for the purchase because of the opportunity cost. This can be especially true when it comes to large purchases.
If you have $200,000 in cash, for instance, you could use that to buy a house outright. You'd have no mortgage and no debt. This is the path some anti-debt experts would suggest.
However, there's another option. Instead of using cash to buy your home, you could take out a mortgage and then invest your cash in the stock market. The average mortgage has an interest rate around 3% at the time of this writing. The stock market has an average return around 7% (over 50 years). If you invest your money instead of using it to buy a home outright, you might earn more on that investment than you'll save by avoiding a mortgage.
When it's an investment in your future
In some cases, taking on debt is less a matter of the debt itself; instead, it's more about making an investment in your future. For example, so long as your business idea is solid, a business loan can be a reasonable investment. A smart entrepreneur can turn a small business loan into a booming business that not only pays back the loan, but provides years of income to boot.
Sure, there are plenty of situations in which taking on debt isn't the best option. If you're living outside of your means, then taking on debt can land you in some serious financial hot water. But to call all debt evil is a vast oversimplification. When used wisely, debt can be an excellent tool for improving your personal finances and your life in general.