A Financial Adviser's Guide to Using Debt to Improve Your Finances
Eliminating high-interest balances and strategically using lower-rate loans can help you use debt as a tool to help make you more money in the future.
With Americans racking up credit card debt at an alarming rate, there is a misconception that all debt is bad. That's not necessarily true.
Debt is a crucial financial tool, one commonly used by the wealthy to increase capital.
Think of the different types of debt most Americans have: Mortgages to buy homes, auto loans to buy cars and student loans to become more educated and increase their future earnings. These are investments that are essential and would be difficult to access without loans.
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Debt is not always bad. It's something everyone can, and should, leverage in some way, as long as you do it responsibly. It's important to understand its place in your financial plan and the situations you can use it to improve your finances.
Understand good debt vs bad debt
To understand how you can leverage debt, you first need to understand the difference between good debt and bad debt. Generally speaking, good debt makes you money or adds value, while bad debt costs money.
Whether debt is good or bad depends on the specific situation. Good debt typically includes mortgages, student loans, investment debt for good value or business debt. Bad debt can include unsecured loans, high-interest credit card debt or payday loans.
A mortgage is typically categorized as good debt because real estate historically appreciates over time, but with current 30-year mortgage rates sitting near 7%, that might not be the best investment long-term.
Student loans, on the other hand, might be categorized as bad debt to some. However, the average worker with a bachelor's degree makes 86% more than one with only a high school degree. Being able to make these distinctions will allow you to not only manage your debt, but leverage your debt to increase capital long-term.
Prioritize controlling your bad debt
You need equity before you can utilize debt, and unfortunately, Americans collectively have more than $1.2 trillion in credit card debt, costing them money and limiting their financial ability. Credit card debt often comes with interest rates above 20%, which makes this very bad debt.
Not only is this costing you, but missing payments can lower your credit score, which could mean facing higher interest rates or being denied for loans, including mortgages and auto loans.
You should prioritize your budget accordingly to pay down your credit card debt.
However, if you have equity, such as a home that you've paid off or mostly paid off, you can leverage this equity to access good debt and improve your situation.
For example, a home equity line of credit (HELOC) loan, which has an average interest rate of 7.30% to 7.50%, can be taken out against your home to pay off your credit card debt. This allows you to exchange a bad debt for a lesser bad debt, cut your interest by more than half and make it easier to pay off.
Leveraging good debt
Once you have equity, you can begin to utilize your good debt. There are a variety of ways to do this depending on the circumstances.
Buying a car could be a good example. Let's say you walk into the dealership and have the money to buy a car outright, but when you begin the process of purchasing the car, a loan is offered to you at a low introductory rate. This is typically only an option if you have a high credit score.
If you take the loan, you'll have to make monthly payments, but you can deposit the money that you would've spent to buy the car in a high-yield savings account or a certificate of deposit (CD), which offer returns of around 3% to 4%.
If that's higher than the interest rate on the loan, the money grows faster long-term, and you can access it as needed for monthly payments.
Another way to leverage debt is if you own a business and want to expand. A business loan allows you to borrow to make improvements and add to your revenue.
These are just two examples, but you get the idea. Debt can be a tool to access an asset in the short term and ultimately improve your finances in the long run.
In conclusion
Debt isn't something you should be afraid of as long as you can afford it and are responsible. You need to make payments on time and be smart about what your budget allows.
This depends on your individual financial situation, which is different for everyone, but this strategy is not reserved for the wealthy. Many Americans can leverage their debt, but they either have too much bad debt or don't know where to begin.
If that's you, I recommend speaking with a financial professional who can help you understand your debt and determine how you can leverage it strategically.
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