If you want to get ahead in personal finance, you need to escape the shackles of debt. As we’ve covered, there are three ways of thinking about what debt is:
- Borrowing from your future self
- Signing away your freedom
- Agreeing to pay more than something is worth
Despite these disadvantages, it’s not always a bad idea to borrow money. The golden rule of borrowing says you should only borrow to build. In other words, only borrow when your expected profit exceeds the cost of borrowing.
This rule suggests that you should avoid consumer debt, but it might be okay to borrow money in the following circumstances:
- Student loans
- Buying a house
- Starting a business
Debt isn’t always dumb, but it’s always dangerous. Just because it can be worth it to borrow for a college degree doesn’t mean every student loan in human history has been a good idea.
In this post we’re going to look at some principles to help keep you out of trouble when you do have to borrow money.
Vet the Value of Your Investment
When you borrow money, you want to make sure the thing you are borrowing is truly valuable.
If you’re borrowing money to get a degree in nursing or computer science, chances are your investment is going to reward you handsomely. If you are getting some obscure humanities degree, your prospects are much more bleak.
This is particularly important for students. Don’t borrow money just because it is being liberally lent to you. Make sure you’re getting something that’s worth borrowing money to acquire.
When it comes to buying a house, you need to make sure you understand it’s condition and the amount of work it will need once you purchase it. It also means that you’ve thoroughly compared buying to renting and understand whether buying makes sense for your situation.
If you’re starting or growing a business, you need a solid idea of how you will be profitable. Yes, this could mean a business plan, but preferably you already have proof of concept because you’re making sales and you’re just borring money to scale faster than bootstrapping allows.
Minimize the Amount of Your Loans
More debt = more risk.
When you’re forced to borrow, you want to borrow as little as possible.
For student loans, this means a number of things:
- You should apply for scholarships
- Make sure you graduate on time
- Live below your means so you don’t have to take out every loan you’re offered
- Consider a cheaper state school as opposed to a prestigious but pricey private school
When it comes to buying a house, this means:
- Don’t buy a bigger house than you can afford
- Put down a large down payment
Putting down a down payment of at least 20% will help you avoid paying private mortgage insurance (PMI). Most insurance protects you, but PMI is insurance that you pay for that protects the bank against you. Specifically, against the risk that you default.
A higher down payment also makes it less likely that you’ll end up “upside down” (owing more than your house is worth) if the housing market has a downturn.
Shop Around For the Best Terms
Like anything, you want to make sure you’re getting a good deal. You usually don’t get the best deal taking the first option you come across.
When it comes to getting loans, make sure to get quotes from at least 3-5 lenders.
The most important thing to look for is a low interest rate. The interest rate, the time it takes you to repay the loan, and the amount you borrow are the factors that determine how much total interest you will pay.
Of those three factors, the only one where there is no benefit to you for paying more interest is having a higher interest rate. Paying the loan off over a longer time frame causes you to pay more interest, but it makes each payment easier. Borrowing more incurs more interest, but puts more cash in your pocket. But a high interest rate does nothing for you. It just makes borrowing more expensive.
The interest rate isn’t the only important thing. You should also make sure there are no penalties for paying the loan off early.
When it comes to student loans, you can’t shop around in the same way, but you should compare your options (remember, you aren’t taking out every loan you are offered). Chances are, you will be offered a variety of loans. Check the interest rates and see if any of the loans don’t start accruing interest until after you graduate.
Consider Paying Your Loan Off Early
The earlier you pay off your loan, the less interest you will pay. This is because the interest charge is calculated each month based off your interest rate and the remaining principal.
If you pay a little extra this month, then next month when the interest is calculated, it will be calculated off of a lower principal. Which means you’ll pay less interest. Paying less interest means that more of your payment will go towards principal. And a virtuous cycle is created.
Every extra payment you make means every interest payment will be a little lower for the remainder of your loan repayment. This can save you lots of money in the long term.
When the interest rate is very low, some people don’y mind holding on to their mortgage. They feel like they can get a higher return in the stock market. Most of the time, their right. But the best way to minimize risk is to pay off your loans as quickly as possible.
Again, paying off your loans early is simple: Pay extra every month.
Remember, debt isn’t always dumb, but debt is always dangerous. Borrow when you have to, but do so carefully and sparingly. Be cautious when you borrow, and aggressive when you repay.