9 questions to ask before taking on debt
April 24, 2015
There are few things easier in the digital world than taking on debt. With the swipe of a card or the click of a mouse, you can borrow money in the blink of an eye -- and interest charges can pile up just as fast.
Indeed, the amounts Americans collectively owe today suggest borrowing might be a little too easy:
- More than $10 trillion in residential mortgage debt
- More than $2.4 trillion in other loans, over half of which is student loan debt
- $884.8 billion in credit card debt, on which consumers pay an average interest rate in excess of 13 percent
If you've found debt piling up too quickly in your life, it might be wise to slow the process down by asking yourself these hard questions before you borrow again.
1. Is there a way to use cash instead?
This generally depends on the nature of your assets and the cost of the debt. For example, with bank rates near zero, it may make more sense to use savings for some purchases rather than take on expensive credit card debt. On the other hand, it might be wise to get a little bigger mortgage rather than pour every penny of your savings account into making a larger down payment, because doing so would leave you no cushion against financial setbacks. It also is generally wiser to borrow money rather than pay the tax penalty for breaking into retirement funds early.
2. Is this the most cost-effective type of borrowing available?
Debt seems to be matched up with specific uses, but you can manage things to borrow more cost-effectively. For example, a home equity loan might be a cheaper alternative to credit card debt.
3. What's the ideal repayment term?
Shorter loans typically carry lower interest rates. However, if a longer mortgage or car loan leaves more room in your budget to avoid charging so much on your credit card, you might be better off because mortgage and car loan rates are usually much lower than credit card rates.
4. Will the monthly payments be affordable?
Never borrow without taking a careful look at the repayment schedule, and identifying how you will come up with the money for those payments.
5. Will these payments crowd out other needs in the future?
You might be tempted to charge a state-of-the-art television today, but if you anticipate needing a new computer for your work in a year or so, you have to make sure you can afford to pay for both. If not, decide which is more important before making the immediate commitment.
6. Will the payments jeopardize retirement savings?
It is not just future purchases you need to leave budget room for. Every debt you have to repay can delay building your retirement nest egg.
7. Will the item last as long as the repayment term?
Try to avoid debts that will take longer to repay than the useful life of the purchase. For example, mortgages and car loans are generally offset by the acquisition of an asset with long-term value, but you might want to avoid an eight-year car loan for a used vehicle that might not last you eight years.
8. Will the new debt hurt your credit?
The amount you owe determines 30 percent of your credit score, so be careful because this can lead to a vicious cycle. Heavier borrowing can be made more expensive if lower credit scores raise your interest rate, and in turn higher interest rates make debt more difficult to pay down.
9. Are other lenders offering a better deal?
Never forget that the financial industry is highly competitive, so you should always get multiple quotes on loans, and regularly shop around for better credit card rates.
Remember, banks and credit card companies have invested heavily in the technology for charging purchases and applying for loans because they want the process to be easy. And often, "easy" equals "habit-forming" -- unless you commit to making every new instance of debt a reasoned decision.
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