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USA Today reports that American households with credit card debt owe an average of $16,883 on those cards, and those with auto loans owe an average of $29,539. The numbers keep going up in recent years, and at a faster rate than incomes.
Being deep in consumer debt means you pay more for everything, thanks to interest charges. It can also mean working hard to pay for things you consumed long ago. Owing a lot of money limits your options, and well, it can be stressful.
Given all the problems with debt, you might think you should avoid it altogether. But sometimes borrowing money can seriously improve your financial situation, and therefore, your life. In fact, there are two basic purposes for which borrowing makes sense:
- To make money.
- To save money.
There are obvious examples, like borrowing to start a business or to buy a home. But even in these cases you have to borrow the right way. If you borrow too much or pay too high an interest rate you can be in just as much trouble as with a load of consumer debt.
So to be a smart borrower instead of a stressed debtor, you need to borrow for the right purpose and borrow the right way. With those two goals in mind, let’s look at some examples of how you can go into debt wisely…
Borrow To Invest
Given the stock market’s historic rate of return of 7% to 9%, it might make sense to take out a home equity loan at, say, 5% to invest in stocks.
That 2% to 4% spread (difference between borrowing cost and investment return) can be thousands of dollars in extra income annually. But it’s risky; the stock market can decline for years at a time.
A safer bet is to borrow to investing in real estate — but don’t bet on rising prices. Buy something that will produce net income after the mortgage payment and all other expenses — right from the start.
Had you done that before the last real estate crash, you would have been making money through all the years that followed.
There are a number of lenders and loan types to consider depending on the nature of your investment. For example…
Bank Mortgage Loans – These are great for real estate investments. Stick with fixed rate loans that have no balloon payment due. In other words, aim for a standard 15-year or 30-year mortgage loan if you can get it.
Seller Financing – Having the seller of a property hold a note can save you thousands of dollars in traditional loan costs (origination fees, points, appraisal). Just be sure that you negotiate a fully amortised loan with no balloon payment.
Family Loans – Borrowing from family can benefit you and your lender/family member. For example, maybe you want to be a landlord while your parents just want a better return than they get in the bank. Be sure the loan makes sense for your situation, and have an attorney review the paperwork so you know everything is done properly.
Credit Cards – Borrowing from credit card companies is usually a bad idea, but credit card arbitrage has worked for me at times. For example, I had a new card offering 0% interest for 18 months and I used the card for everything, then put the payoff money in the bank, paying only the minimum due each month, effectively borrowing $6,000 at 0% and investing it at 2% to 5%.
Credit Card Convenience Checks – I once used a credit card convenience check to borrow $5,000 at 4%, and then loaned the money out at 9%. I wouldn’t recommend such a risky transaction, but I knew the borrower and his situation very well. He needed to buy inventory to expand his business, and he was able to pay me back easily as he sold the goods.
Borrow To Start Or Expand A Business
But many businesses require a fair amount of capital. A carpet cleaning company, for example, can take tens of thousands of dollars to start, as can expanding a restaurant to new locations.
If you don’t have the necessary cash saved, borrowing to start or expand a business can be a great idea — when done right. You should have a clear plan for repayment, and the money borrowed should produce additional profits far in excess of the borrowing cost.
The right kind of loan helps. Here are some options…
Small Business Administration (SBA) Loan – The SBA guarantees loans made through local banks, and they also have a microloan program for smaller loans. The terms are usually better than you can get elsewhere, and the process requires you to have a decent business plan, which can keep you out of trouble. The SBA has resources to help to create this plan too.
Friends And Family – Loans don’t work in some families (and if that’s your case, just avoid this option). But if you and your family members are business-like about lending and borrowing, it can be great for both sides..Have a clear repayment plan, put it in writing, and have a lawyer review it.
Lending Club Small Business Loans – You can borrow up to $300,000 on this peer-to-peer lending platform. They have advisors to help you, and offer rates as low as 6% (expect a much higher interest rate for startups and most expansions).
Your Home – There are a number of ways to borrow against the equity in your home, including refinancing it, getting a home equity loan, and getting a second mortgage loan. As long as you document the purpose and use, interest should be tax deductible. The IRS says, “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.”
Borrow For A Home
However, a home can be a “save-money investment,” meaning you can be further ahead versus renting — if you do it right. The key is to buy a home with total expenses that are less than what you would otherwise pay in rent.
That includes the interest you pay on a home loan, so look for the lowest cost among the following types of loans…
Bank Mortgage Loan – It’s easy to find lists of the best mortgage rates online, but be sure to also consider the fees and other costs.
Seller Financing – I’ve bought using seller financing and I have taken a note back on properties I’ve sold. It’s a way to save thousands of dollars in loan costs, because traditional lenders require not only fees and points, but also make you pay for an appraisal and other costs. Get a fixed rate, and no balloon payment.
Friends And Family – I’ve seen enough family loans work well (yes, even for real estate) that I know they can be a good idea. Just be sure both sides understand all the possible outcomes (including foreclosure), and have an attorney review all paperwork.
Borrow For Education
Going into debt for college can make sense if the result is a lifetime of higher earnings, at least if you get one of the degrees with the best return on investment. Otherwise you might yours add to the many student debt horror stories.
Speaking of which, did you know that over 2 million students have educational debt that tops $100,000?
Borrow as little as necessary, even if that means you have to take more time to get a degree, or work while attending college. Investopedia suggests that your total student debt should be no more than half of your expected first-year salary after graduation. And borrow smart, using one of the following…
Federal Student Loans – These have low interest rates, and there are loan forgiveness options if you happen to get into financial trouble. Before you borrow anything, see if you’re eligible for Pell Grants or other free money.
State Loans – These too usually offer low interest rates, but first apply for any state-sponsored scholarships and grants, of course.
Private Student Loans – You can find lists of the best private student loans online. Consider carefully the terms according to your plans. For example, if you plan to pay off the loan quickly you want one without a prepayment penalty.
Borrow To Consolidate Debts
Borrowing to consolidate your debts can cost you more, even with a lower interest rate.
For example, if you have credit card debts at 18% interest, and you roll them all into a new home mortgage at 6%, you might pay on those debts for 30 years instead of 5 or 10 years, and so pay more total interest, even at the lower rate.
So if you borrow to consolidate debts, aim for as short a term as you can handle, to keep your total cost lower. Here are some of the ways to borrow for this purpose…
Get A Peer-To-Peer Loan – Social-lending websites like Lending Club and Prosper are used extensively by people consolidation their debts. Use these loans carefully, and only if you have a decent credit score and so can get a good rate. Also, be sure to consider the fees (as high as 5%) when calculating whether you will save money.
Get A Home Loan – Consolidating debts into a new home loan usually means paying more in interest because of the longer term. However, if you get a second mortgage loan just for this purpose, and it has no prepayment penalty, you can pay as much as possible every month to pay the balance off quickly, and at a much lower interest rate.
Borrow From Family – Borrowing from your parents or other family members instead of a bank or social lending site will save you money on fees, and (perhaps) interest. Your lender will pay taxes based on the Applicable Federal Rate even if they don’t charge interest, so be fair and pay a fair rate. And put everything in writing.
Other Ways To Borrow
In addition to the types of borrowing covered above, here are a few more, which should mostly be avoided…
401(k) Loan – Generally it’s a bad idea to borrow from your retirement funds. You don’t want to arrive at retirement with nothing but a bunch of IOUs to yourself. But the “interest” you pay does go to yourself, and there may be times when it makes sense to borrow from your 401(k).
Credit Card Cash Advances – The average interest rate on cash advance loans is 23.53%, and you typically pay a 5% fee up front. This is almost always an awful way to borrow.
Pawn Shop Loans – Nolo.com says some pawn shops charge rates that work out to 240% on an annualized basis. You’re probably better off just selling that stuff rather than pawning it.
Payday Loans – According to the Consumer Financial Protection Bureau, “A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400%.” We have a winner for the worst way to go into debt.
To go into debt wisely, remember to…
- Avoid consumer and other “bad debt.”
- Go into debt for things that make money or save money.
- Borrow only when the interest rate and terms work for your purpose.
If you’ve been a wise borrower, tell us about your experience below … and keep on frugaling!