Monday, June 1, 2009

To Borrow or not to Borrow

Today let's look at the financial side of decision-making, especially the question most of us face at one time or another about borrowing money. Credit is the ultimate two-edged sword. Few people can own homes without borrowing to buy them. Many of us need to borrow to get a car to get to work. Some people can establish profitable businesses, but only if they can borrow the money to get started.

On the other hand, debt can ruin lives unless we are careful. This is today nowhere more apparent than in the world-wide economic problems we face. Those problems were mostly created by loans, especially mortgages, the borrowers could not repay. Many of those loans should never have been made and the borrowers should have refused to take them.

We can find plenty of people to blame for those bad loans. Congress promoted unwise loans to help people buy houses they could not otherwise afford (and sadly couldn't afford even after congress helped buy them). Lenders failed to stand up to congress, instead jumping on the gravy train for what they thought would be easy profits. Borrowers did not adequately consider their ability to pay off the loans. There is plenty of blame to go around, but let's concentrate here on the future and how each of us as individuals can decide wisely about borrowing money.

I like to divide debt into two categories, investment and consumption debt. Consumption debt is for things like vacations, fancy TV, and other extravagances. Investment debt is for things that provide a return on your money such as starting a business or getting a car to get to work. Of course some debt can be partly consumption and partly investment. Investing in a car may help you get to work, but borrowing to buy a more expensive car than you need makes that debt partly consumption and only partly investment. In my opinion you should never take out consumption debt. Save your money and pay cash for that new stereo. However investment debt may be useful if carefully considered.

What is a good loan? To be honest, there are very few such critters inhabiting this planet. However there are useful loans that can do you enough good to overcome their bad points. A loan can be useful if:

1. The loan is the only reasonable way to get something you really need, or that will provide a return on your investment.

2. You have carefully planned how you will pay off the loan, including preparation for the unexpected.

3.You are not borrowing to acquire more than you really need. If you are starting a business, for example, you are not buying fancy stuff that will be out of style next year and everything you buy will return the investment.

4.You have considered alternatives to borrowing but careful evaluation shows that they are not feasible.

And don't cheat by borrowing for the investment while using cash resources for unwarrented consumption purposes. Don't use your savings for an expensive vacation while borrowing for a car to get to work. Yes, I know you need some relaxation but you don't need a European vacation or anything similar. There are lots of less expensive options that are quite enjoyable.

The biggest problem with debt is that it tempts us to spend money we don't have on things we don't need. How many people really need a $20,000 car? The first few miles you put on that shiny new vehicle will depreciate its value considerably. It is much more cost effective to buy a good used car. Yes, it may have a few problems but if you are careful you can avoid most of those problems and be prepared for the rest. Have a good mechanic check the car before you sign any papers, many will guarantee that evaluation and fix any problems they don't find. Sock away a bit of money for emergency repairs and you will still be paying much less than the cost of a new car.

Remember, debt never sleeps and is always sucking money out of your pocket. Incurr it only for good reasons and after carefully considering all aspects of the loan.

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