Making Sensible Use of Debt

Despite the constant media harping about the evils of debt, borrowing, i.e., using other people's money, is an essential tool for achieving financial security. In our society, you can borrow to acquire just about anything, but there are very few things that are worth going into debt for. Here's the caveat in seven words: Never borrow to buy a depreciating asset. In other words, don't borrow for something that isn't going to provide you with lasting and ever-increasing benefits in the future. That pretty much leaves out most of things that people borrow money for. Most people borrow to finance either current spending or to buy something that loses value over the years, like a car.

Three worthwhile reasons to borrow. There are three things that qualify as appreciating assets and are therefore candidates for using your good credit:

  1. A home. While the majority of homes in this country are owned free and clear, most of them didn't start out that way. A home is the perfect example of why borrowing can benefit you in the future. You borrow to buy a home, work assiduously to pay off the mortgage, and forever after enjoy owning a mortgage-free domicile. All the while (well, at least most of the time) the value of your home is appreciating. Anyway, this scenario works so long as you resist the temptation to use your home as a personal piggy bank to borrow for stuff that depreciates in value.

  2. Education. Education for your kids or yourself is an expensive proposition – one beyond the immediate resources of most families. Despite your best efforts to secure scholarships, grants, gifts from wealthy aunts, you may have to borrow to pay burgeoning college costs. Education is a great reason to borrow, because your return on investment is not only high, but should last for decades, long after you've paid off those annoying student loans.

  3. Sensible home improvements. Home improvements fall into two categories: the sensible and the preposterous. The acid test is not how good the improvement makes you feel; rather, it's how good the improvement will make the future buyer of your home feel. Worthwhile improvements add substantial value to your home and, therefore, are worth borrowing for, particularly if the alternative is to move into a more expensive manse.

A riskier reason to go into debt. Investment real estate is so costly that it's the rare person indeed who can afford to pay cash for it. Borrowing to invest in income-producing real estate can work very well, so long as you avoid overpaying for the property. But even if you acquire a property at a good price, investing in real estate is still a risky proposition.

High risk borrowing. There are two other areas where borrowing may reap substantial rewards, but these are riskier still, compared with borrowing for a house, an education, and home improvements. This duo is borrowing to invest in stocks and bonds and borrowing to start or sustain a business. While you (or your investment advisor) may think you have a Midas touch in selecting winning investments, investing in stocks, bonds, and mutual funds with borrowed money (called investing on "margin") can result in very large investment losses if the investment markets go against you. Borrowing to start a business or to sustain a business that may be suffering is even riskier.