When Debt Is Smart

By Katherine Reynolds Lewis
c.2007 Newhouse News Service
Illustration by Monica Seaberry

Americans are drowning in debt. Advice abounds to cut up the credit cards, rethink the car loan, and step away from the home equity line.

But in many circumstances, debt isn't simply acceptable, it's the best option. After all, without a mortgage or student loan, many people would never own a home or graduate from college.

"It can be smart to have debt because it means you have other people's money going to work for you,'' said Kenneth Shapiro, a financial security adviser in Hazlet, N.J.

Here are six key questions to ask before taking out a loan, or deciding to pay one off early.

1. What is the loan's purpose?

"You want to have debt that is balanced out by an asset,'' said Larry Friedman, a certified public accountant in Cleveland.

Borrow money to buy real estate, not to go out to dinner — the extra pounds on your hips aren't an asset. Borrow only for something that will provide value for as long as you'll owe the money. So don't take out a 30-year loan for a car you expect to drive five years.

"You don't want to have the loan still around when the asset isn't around anymore,'' said Andy Weidman, Wyomissing, Pa.-based president of the Pennsylvania Institute of CPAs.

2. What is the true cost of the loan?

Mortgage and investment interest can be deducted from your federal income, which gives you a lower effective interest rate.

To figure out the savings, multiply your interest rate by your tax rate. For example, if you're paying 7 percent on a loan and you're in the 34 percent tax bracket, your tax savings are 2.38 percent. Subtract and you get the true cost of borrowing: 4.62 percent, says John Pridnia, a certified public accountant in Muskegon, Mich.

This loan makes sense if you can put the money in an investment that you're positive will return more than 4.62 percent after taxes, Pridnia said.

You pay the highest interest rate when you carry a credit card balance, making cards usually the most expensive way to borrow, said Dennis Echelbarger, a certified public accountant in Grand Rapids, Mich. Credit card interest isn't deductible.

3. Can you afford the payments?

If you've been comfortably paying $1,000 a month in rent and buy a house with a mortgage payment close to $1,000, it will fit in your budget. A $3,000 monthly mortgage bill may be another matter.

Don't rely on the bank's loan officer to tell you what you can afford, said Ted Sarenski, a financial planner in Syracuse, N.Y.

"What they may allow and what you might be comfortable with might be two different things,'' Sarenski said.

4. What's the worst-case scenario if your plans, or interest rates, change?

Many homeowners are being pinched as adjustable-rate loans get more expensive with rising interest rates. At the time of the loan, you can limit your risk with a cap on the adjustable rate, Friedman said.

Student loans often are seen as an investment in yourself. That's accurate only if you can get a job with a salary high enough to repay the loan.

"We have people who run up a lot of student loans and they never get a degree, or that field doesn't pay very well,'' said Rebecca Pace, a financial planner in Cincinnati.

Take out a student loan only if you're committed to finishing, Pace advised.

5. If you don't borrow, is your alternative better or worse?

The $15,000 in cash you pay for a car might have been put into your 401(k) plan. Remember, you can borrow for a car, but not for retirement.

It's a truism that you can get credit only when you don't need it — by the time you're in a cash crunch, you're considered a bad loan risk. If you keep a cushion in your savings account, rather than using the money to pay down debt, you're covered in an emergency.

That way you don't have to worry about your bank canceling your home equity line of credit just when you need it, Shapiro said.

"I want as much credit as I can have because you never know when you've got a crisis that you'll need it,'' said Richard Noreen, a certified public accountant with BDO Seidman in Grand Rapids, Mich.

Remember, if you never borrow, you'll have no credit history. That makes it hard to qualify for a mortgage or other loan.

One way to build a history is to make purchases with a credit card and pay the balance in full every month, Shapiro said. Or take out small loans and always pay them on time.

A track record of regular payments will lower the interest you have to pay on future borrowings, he said.

6. How secure is your income?

Think about any circumstances that might put your income at risk, and what you could do to keep up loan payments in an emergency, said Echelbarger.

(Katherine Reynolds Lewis can be contacted at katherine.lewis(at)newhouse.com)

This story was originally published Tuesday, April 3, 2007.