When It’s Okay to Carry Debt

Posted on: June 16th, 2010 by

Financial Planning - Rockville, MDFederal Reserve Chairman Ben Bernanke has told Congress that “the federal budget appears to be on an unsustainable path,” but that that the “exceptional increase” in the deficit had been necessary to pull the country out of recession.  That raises a question everyone should consider: When is debt okay and when is it not? After all, everyone has financial rough spots.  The federal government is a good example of what ordinary folks should not do: pile debt upon debt forever, taking out new loans to pay off old ones.

In one of its most dangerous practices, the government uses short-term borrowing to fund long-term obligations.  That seems to work fine when interest rates are very low, because rates are lower on short-term loans than on long-term ones.  But later the borrower may have to take out new loans at higher rates, having passed up the opportunity to lock in a low long-term rate when it was available.

This is what homeowners do when they choose adjustable-rate mortgages over ones with fixed rates, or when they use one credit card to pay off another.  So the first lesson the dysfunctional Federal government teaches us is: don’t finance long-term obligations with short-term loans.  Don’t use an 18% credit card to fund a home addition that will take years to pay off.  If you must borrow for that, take out a home-equity loan.  The rate is likely to be half as much.

What about borrowing in an emergency?  In a real emergency, you can justify almost anything.  A legitimate emergency is a serious illness, or a car problem that will keep you from getting to work, a leaky roof that will ruin your home.  The need for a vacation is NOT an emergency.  Basically, an emergency is something that will seriously undermine your life for years, not something that will put a little damper on your lifestyle.  If necessary, borrow to get basic, essential transportation, not to get luxuries like leather seats and navigation systems.  Of course, the average American is borrowing all the time, using credit cards for everything from gas to groceries to clothes and entertainment.  Credit cards should be used for convenience, so you don’t have to carry cash.  Balances should be paid off in the grace period to avoid interest and other charges.



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