credit & debt

When is it Worth Going Into Debt?

What you need to know before you whip out your plastic or fill out a loan application.

To charge or not to charge? That's a question I hear a lot. Is it okay to go into debt for a wedding ring? Grad school? A car? Travel? Furniture?

I'll break down these specifics later. But first, what you're really asking is if going into debt is worth it.

The short answer: It's usually not. When you're in debt, you limit your options and you have less control over your money and your future. You're forking over interest to the bank or credit-card company instead of investing the money in yourself. And especially when you're young, that forces you to lose out on some hefty long-term rewards.

Even in today's tighter financial market, credit comes easy, making it tough to discipline yourself against going into debt. Temptations are everywhere. But just because the loan officer tells you that you can afford the payback terms doesn't mean it's a good idea. It sounds plain and simple, but the sooner you adopt this mindset the better: If you don't have the money, don't buy it.

Of course, there are exceptions, gray areas that make you say, "yeah, that sounds nice, but what about..."

Here is the defining question you should ask yourself before you whip out your plastic or fill out that loan application: Will this purchase appreciate in value? If so, the debt may be worth it.

Dump the losers

In other words, ask yourself if it's a builder or a loser, says Howard Dvorkin, founder of the nonprofit Consolidated Credit Counseling Services. That means, for example, an education and a house are worth the investment, he says. "An education enhances your job prospects and allows you to build greater wealth, and a home increases in value over the long term," he says. On the contrary, something like a car is a loser. "It loses value as soon as you drive it off the lot."

Another way to look at it: If you had to raid your savings to pay for this, would you?

This is a lesson in deferred gratification. But the payoff is well worth it. For example, say you charged $5,000 to your credit card to buy a new TV and sound system. If you make the minimum 4% payment each month and the card charges 18% interest, it'll take you 12½ years to pay the balance off -- by that time you'll be ready for another TV. Plus, you would have paid an extra $2,900 in interest.

Imagine taking $2,900, crumpling each bill in your fist and tossing it into the trash can. Instead, if you had invested $2,900 for 12 years earning an average 8% annual return, it would be worth $7,550. Your money -- and time -- obviously could have been managed better.

What if going into debt for a loser is absolutely unavoidable? If you really have no other choice and it's something you truly need (not want -- you've got to know the difference), make sure you think of a repayment strategy in advance. For credit-card purchases, for example, set a goal to pay it off in three months to keep your wasted money to a minimum. Sit down with your budget ahead of time and highlight areas where you can cut back to come up with the extra cash to pay the bill. (See Save Money on Practically Everything for inspiration.) You should never go into debt lightly.

Of course it's smartest not to charge at all. The sooner you can implement the cash-only strategy, the more freedom and control you'll have over your finances. Get in the habit of setting a little aside each month into a savings account for your goal, be it a wedding ring, a vacation, a car or some mad money for when the mood to spend strikes. (This is in addition to your emergency savings cushion.)

A debt-free lifestyle may take a while to attain, but it's infinitely better to earn interest for yourself than pay it to someone else.

Getting specific

Let's put our earlier examples to the test. To charge or not to charge?

Wedding ring: NO. When it comes to all things wedding related, say no to debt. "The number-one reason for dissolution of marriage in this country is financial pressure," says Dvorkin. Starting out your life together in debt is like pouring fuel on the fire. It's hard enough combining your lives and finances without having to deal with extra wedding-related debt. Go with a conservative wedding ring and upgrade later. Scale down your wedding and start saving for a dream anniversary vacation.

Grad school: YES, with caution. Presumably, an education is something that increases your earnings power. That said, you shouldn't make this decision flippantly. Take an honest look at your career path and motivations. Will a graduate degree significantly improve your prospects in your field? Or are you crossing your fingers and hoping for the best? Are you stalling your entry into the real world because you aren't sure what you want to do?

Be smart about going into debt for your undergrad degree, too. Does going to an expensive big-name school make sense for your field of study? Would a cheaper school give you a quality education for less coin? (See Pay for College Without Breaking the Bank for more.)

Car: SOMETIMES Ideally, the answer to this one would be "no" -- a car is not worth going into debt for because it depreciates in value over time. But when you're starting out, scraping up enough cash to buy your first set of wheels to get you to and from your job can be a tall order to fill. If you're lucky enough to live in a city where you can do without a car, by all means, take public transportation and save your money. But if you absolutely need a car, you may have no choice but to get a loan.

The key is to keep it simple. New cars lose half their value in the first three to five years, so it makes more sense to consider a reliable used car that has already suffered the steepest depreciation (see some of our favorites). The goal here is to pay it off as soon as possible so you can start saving money toward buying your next car with cash.

Travel: NO This is an easy one to justify the other way. After all, you're only young once and this opportunity to get away may not present itself again. Although the memories may last a lifetime, so can the bill. If you charge $3,000 to a credit card at 18% interest, and you make the minimum 4% payment each month, you'll be paying for your getaway for the next 10½ years, plus $1,700 in interest. Is it really worth the shackle and the money wasted?

Furniture: NO You finally have a place and you're excited to make it your own. But keep it basic. "You're not in GQ. You're not in Vogue," says Dvorkin. Buy used or cheap furniture at first. Craigslist.org, Freecycle.org and your local thrift shop are great places to start looking. You can always upgrade later as you become more established.

Home: YES If you plan to stay put for at least five years, going into debt to buy a home can be a good move. But it only makes sense if you can afford all the related costs. Home ownership requires more than just a mortgage payment. You also need to come up with a down payment and closing costs, not to mention the expense of property taxes, insurance, maintenance, repairs and higher utility bills (see The True Cost of Owning a Home).

And remember, just because the bank says you qualify for a certain dollar figure doesn't mean you should take it. Figure out how much home you can realistically afford. Then, see How to Know When You're Ready to Buy to make sure your finances are in order before you take the plunge.

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