At first glance, the data looks bleak: Nearly three-fourths of Americans are in some kind of debt. While that may sound troubling, consider that not all debt is bad. In fact, borrowing sums of money with a legally bound promise to pay it back can help you build a healthy credit history and demonstrate trustworthiness to financial institutions. It can also provide the leverage needed to invest in assets that appreciate over time – proving a major milestone on the path to building wealth.
Credit: The Fruit of Debt
As many millennials are discovering, there’s a downside to their preference for cash and debit cards: a lack of credit history. Failing to engage with debt responsibly means that when it’s time for a new car, house, or small business, lenders may be leery about agreeing to better loan amounts and interest rates. Opening and responsibly utilizing a credit card is a great way to demonstrate your ability to make good on debts. The key here is to pay off your credit card every month. Also, keep monthly credit card charges below 30% of the card’s available credit limit. Over time, this will demonstrate your ability to manage revolving credit and will strengthen your overall credit score. Whether you’re starting from scratch or repairing bad credit, building a solid credit history takes discipline, consistency and time.
Leverage: The Advantage of Debt
Debt is essentially leverage; you are using someone else’s money now, to buy what you want now. In return, you are forfeiting your future money to repay the loan (plus interest). If you buy something that will be worth more than what you paid for it, then the debt is leveraged in your favor. If you end up paying more than the future value of the purchase, then the debt is leveraged against you. This first kind of debt can help build wealth over time and the second can be a drain on your ability to accumulate wealth. Therefore, the two questions that need to be asked when considering taking on debt are:
1. Is the debt leveraged for me or against me?
2. Can my current cashflow tolerate the payments on this debt for the duration of this loan?
If the answer to both of these questions is ‘yes’, the debt has the potential to work for you in growing your net wealth over time. Let’s look at two basic examples:
Is the debt leveraged for or against me? Generally, houses / real estate appreciate in value over time and can add value in growing your net worth – Therefore, the debt is leveraged for you.
Can my current cashflow tolerate the payments on this debt for the duration of the loan? If you can afford the monthly mortgage payments without worrying about your other financial obligations, your cashflow can tolerate the payments of this loan. Since the answer to both of these questions is ‘yes’, we can expect for this appreciating asset to grow your net wealth over time.
1. Is the debt leveraged for or against me? We’ve all heard the line – a new car loses up to 20% of its value the second you drive it off the lot. A car will only continue to depreciate in value as you own it. Therefore, this is an example of debt that is leveraged against you.
2. Can my current cashflow tolerate the payments on this debt for the duration of the loan? Even though car loans are leveraged against you, you might really want that new car with all the bells and whistles. If this is the case, just make sure the answer to this second question is ‘yes’. Never commit to loan payments based on an expectation (or hope) of a higher future income and better cashflow .
You don’t want to avoid borrowing money entirely, but you do want to practice good credit hygiene. If done responsibly, you’ll find that both your credit score and net worth will benefit positively – working for you in your ability to Build a Rich Life.
David Kern is a Wealth Management Advisor at Wealthquest – a Cincinnati based financial planning and wealth management firm that offers a full range of financial services under one roof, for one simple fee.1