Penny-wise and pound-foolish?
Consumer debt has gotten a bad rap, as many Americans have dug themselves into deep holes of debt that are almost impossible to overcome. But the truth is, there are wise ways to use debt and there are foolish ways to use debt, says NPR correspondent Chris Farrell in his book “The New Frugality.”
According to Farrell, wise debt is productive and foolish debt is consumptive. While that seems like common sense, “it’s a concept people forget over and over again,” he says. “Before the recession, good debt and bad debt got mingled.”
So before swiping your credit card or signing on the dotted line, how do you determine whether you’re getting yourself into wise or foolish debt? These tips will help you decide.
Can you pay off your balance?
Tyler Tervooren, author of the blog Advanced Riskology, uses credit cards for almost every purchase he makes, but he pays the full balance every month so he never owes a finance charge.
“My strategy is to use them to accumulate frequent-flier miles that will allow me to travel the world practically for free,” Tervooren says. “I track all my spending and stick to a budget using Mint.com.” Mint.com is an online money management and budget-planning site.
Still, most people carry credit card debt, Farrell says. “So many of us say we pay off our credit cards at the end of the month, but in reality we may be carrying $1,000 or $2,000 in debt,” he says. But for those who are disciplined enough to actually carry a zero balance, this is a great way to use a credit card.
Is there a cost of not borrowing?
Borrowing money to buy a car may seem consumptive rather than productive, but it depends on the situation. Say you need a car to get to work, but yours is unsafe and keeps breaking down — which costs you time and money.
“If you can only afford to pay cash for a replacement car that costs $1,500, you won’t get a very good car,” says Syble Solomon, an executive coach and an international speaker on the psychology of money.
Do experiences trump possessions?
No self-respecting financial professional would advise young adults to rack up credit card debt to purchase the latest shoes, cell phones or iPods. But, using a credit card to pay for a once-in-a-lifetime experience that can make you more employable and world-wise could be worth the interest payments.
“For younger people, particularly recent college graduates, it is a wise use of debt to pay living expenses to do time-intensive things such as backpacking in Asia for several months, going on a religious mission trip or working on a poorly-paid artistic or musical project,” says Eli Lehrer, national director of the Center on Finance, Insurance, and Real Estate of The Heartland Institute, a national, free-market think tank in Washington, D.C.
“Since time is money, once a person gains career experience and family obligations, the opportunity cost of doing these things (early in life) dwarfs the interest one would pay on a credit card,” Lehrer says.
Covering credit card debt with loans
Traditionally, 30-year mortgage loans as well as student loans to pay for a college education have been considered wise debt. However, in recent years, many consumers have used this wise debt to pay off their consumptive debt, confusing the two types of debt and extending the time it takes to pay for everyday purchases.
For instance, many people use a home equity line of credit, or HELOC, to pay off credit card debt, assuming that the tax incentives that come with a HELOC makes it a wise decision.
“The sad reality is that the majority of homeowners who do this, upwards of 70 percent, will not adjust their corresponding spending habits and will, within a year or two, charge their credit card balances right back to where they were when they paid them off with the HELOC,” says Todd Christensen, director of education at the National Financial Education Center at Debt Reduction Services Inc., in Boise, Idaho.
“Like using a HELOC to pay off consumer debt, using a student loan to pay off credit card debt means that 10 years after graduation, the student will finally pay off the pizzas and music downloads he purchased in college,” Christensen says.
Are you using float to your advantage?
Say your clothes dryer tumble-dries its last load. You’ll be able to pay for a new one after payday in a couple of weeks, but you need to do laundry now. A wise way of using credit cards is to “use the 30-day float,” says Tim Chen, CEO of NerdWallet.com, a credit card research site. Float is the grace period between making a credit card purchase and paying your bill in full to avoid interest charges. That means, buy the dryer now, and pay for it later in the month when you get paid.
“Using a credit card for the 30-day float between the time you buy something and the time you have to pay can be wise, as long as you pay the bill off on time,” Chen says.