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Going into debt is not necessarily a bad thing. In fact, it can be a great idea. It all depends on your reason for borrowing and on how you borrow. We’ll get back to the how, but let’s briefly look at the reasons you might borrow money.
When explaining good debt” and “bad debt, experts point out that the latter makes you poorer.
For example, when you borrow for a vacation, or get a car loan, or finance consumer items like furniture, you’re worse off financially. The debt load alone can be a problem, and because of interest charges you pay more for everything you buy on credit.
So what is good debt? Author Robert Kiyosaki says the common advice to “get out of debt” is a lie “perpetrated on the poor and middle class by the rich.” He points out that, unlike bad debt, which buys liabilities, good debt buys income-producing assets. But perhaps that’s too simplistic. Here are three good reasons to borrow:
- Borrow to Make Money
- Borrow to Save Money
- Borrow to Resolve an Emergency
The first reason is easy enough to understand. Debt that starts a successful business, or buys income-producing real estate can certainly make you richer. Add to that your student loan debt, at least if the college degree it buys will increase your lifetime earnings. Even a car loan might be good debt, if you have no way to pay cash and no other way to get to work.
Debt that saves money can also be called “good.” For example, although Kiyosaki says your home is not an asset, it can cost less than renting, even with mortgage payments. Borrowing to install solar panels makes sense if the savings are greater than the cost, including interest charges. Just about any debt that costs less than it saves can be called good debt.
The third reason can be debated. Most “emergencies” can be planned for in theory. For example, since you know a heater will die someday, and probably in the middle of winter, you could save for that eventuality instead of going into debt when it happens. On the other hand, if you borrow for a an unexpected life-saving surgery for a loved one, it seems appropriate to call that “good debt” (or at least necessary debt).
So there are some bad and some good reasons to go into debt. But how you borrow also makes a big difference in the results you get. So let’s look at some of the best ways and worst ways to borrow.
Worst Ways to Borrow Money
Okay, you need to borrow to make money, save money, or for an emergency. But before we look at the best ways to do that, here are some of the options you should probably avoid.
A Peer-to-Peer Loan
Borrowing money on social-lending websites like Lending Club and Prosper is included here and on the list of the best ways to borrow because the reason for the loan matters. Interest rates are low only if you have a great credit score, and loan origination fees add up to 5%. For most “good debt” purposes you’ll do better borrowing elsewhere.
A Credit Card Convenience Check
CreditCards.com points out that credit card convenience checks are a form of cash advance, and so come with high costs. But since some of them offer low fees and even 0% interest for a set period of time, this can be inexpensive short-term debt, as long as you pay off the balance before the teaser rate expires. If not, you’ll soon be paying big interest charges.
A Credit Card
The average interest rate on credit card purchases is around 15%. Since there are no safe investments that earn more than that (and credit cards generally can’t be used to buy investments anyhow), this is almost always a bad way to go into debt. But not as bad as…
A Regular Cash Advance
Unlike with some convenience check offers, you pay top rates when you go for a regular credit card cash advance. The average interest rate on a cash advance is 23.53%, about 8% higher than the rate on purchases. Also, you typically pay a 5% fee up front.
A Pawn Shop Loan
Credit card and cash advance interest rates are bad, but not nearly as bad as those at pawn shops. According to Nolo.com some pawn shops charge interest rates as high as 240% on an annualized basis. Rather than borrowing against your things, you’re probably better off just selling whatever you no longer need.
A Payday Loan
The Consumer Financial Protection Bureau says, “A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400%.” That makes this one of the worst ways to borrow for any purpose.
Best Ways to Borrow Money
Now that you have been warned away from the more questionable ways to borrow, here are some better options.
A Mortgage Loan
Mortgage loans have some of the lowest interest rates out there. Of course it’s only “good debt” if it makes you richer, and betting on appreciation is speculative, so you might want to buy a home with total expenses that are lower than what your rent would be.
If you already have a home there are several ways to tap into your home equity. These include a home equity line of credit, a second mortgage, and refinancing. They each have advantages and disadvantages, but if you have good credit the interest rates in each case should be low enough to use this kind of debt for profitable investing.
Interest on your home mortgage loan is tax-deductible, which further lowers the cost of this debt. You may also get a tax break on other mortgage debt. According to the IRS, “The interest you pay on a mortgage on a home other than your main or second home may be deductible if the proceeds of the loan were used for business, investment, or other deductible purposes.”
Of course anytime you have a mortgage loan on a rental house the interest is a tax-deductible expense. And refinancing a rental property can be a good way to borrow money for additional investments, in part because all the loan costs are tax deductible.
A Peer-to-Peer Loan
Sometimes borrowing through social lending websites like Lending Club or Prosper makes sense. One example is when you can consolidate higher-interest debt at a lower rate. Just be sure that you’ll save money. It’s easy to forget about loan fees, and even easier to forget that you don’t necessarily save money paying a lower interest rate if you end up paying for ten years instead of five.
It also makes sense to use peer-to-peer loans for starting or expanding a business. Use their regular platforms if you’re just starting or, to expand (if you have two years in business), try Lending Club’s small business loans. You can borrow up to $100,000 without collateral, at fixed rates starting below 6% (plus an origination fee).
A Small Business Administration Loan
If you’re borrowing to start or expand a business and can’t get a traditional bank loan, you also might qualify for an SBA loan. Some of their programs guarantee loans through banks, but they have other options, including a microloan program for smaller amounts.
The nice thing about borrowing in this way, apart from being potentially more affordable, is that the process requires you to have (and helps you to have) a decent plan. That can force you to fully prepare, and so keep you out of trouble.
A Student Loan
Borrowing for college can result in a lifetime of higher income. On the other hand, the average student loan debt for a class of 2016 graduate is over $37,000. Then there are the many student debt horror stories that make it clear how much trouble you can get into. So you might want to aim for one of the degrees with the best return on investment.
A 401(k) Loan
When does it make sense to borrow from your 401(k) retirement plan? When you have a sure plan for repayment and you would otherwise borrow the money elsewhere. Since any “interest” you pay goes to your own retirement plan, these loans, if done right, are essentially interest-free. If done wrong, you might have to get a job to cover the bill when you’re eighty years old. So be careful.
A Personal Loan
Why not borrow from family or friends? If you have a good purpose for the debt, and a solid plan for repayment, a personal loan can benefit you and the lender.
Your friend or sister may have to pay taxes based on the Applicable Federal Rate whether or not they charge interest, so be fair and let your lender make a profit. Business is business, and you aren’t going to borrow just for a “bad debt” purpose like a vacation or big TV, right?
What are the best and worst ways you’ve borrowed money? Tell us your stories below.