October 27, 2009 in Business

Consider risks, benefits before you add to debt

Loran Graham
 

Over the past several decades, consumer culture has been built largely on debt and encouraged borrowing to help individuals fund lifestyles beyond their means. The numbers are sobering. Approximately one in every eight homes in the U.S. is now either in foreclosure or moving toward foreclosure. Credit card borrowing has reached nearly $2.6 trillion, and it is estimated that only 40 percent of the 984 million credit cards that consumers carry are paid in full each month.

What are some of the dangers?

1. Debt presumes upon the future. The assumption is that you will earn the income required to pay it back in the future. But in reality, no one knows what the future will bring. The recent financial crisis certainly proves that.

2. Borrowing mortgages the future. You may be forced to work longer hours to support the debt payments, or postpone other long-term goals as you send money to creditors that would otherwise be available for saving.

3. Compounding interest is working against you. It’s a lot easier to get into consumer debt than to get out, because interest is constantly being added to the balance you owe, and the payments you make are with after-tax dollars.

The rules of borrowing

When might borrowing make economic sense? The first question to ask: Am I borrowing to purchase an asset or an expense?

By definition, an asset has the potential to appreciate or produce an income. Examples might include a home mortgage, buying a business, or funding a college education that will lead to higher earning potential.

Other questions to ask: Would the economic return be greater than the economic cost? Would the loan payment be manageable? Do I have peace of mind when I anticipate making this borrowing decision? Even if the answer is yes to all, count the cost and develop a realistic repayment plan before you borrow. Spouses should also be in agreement.

Establish an emergency fund

What about those emergencies that always come up, such as a car breaking down, a medical procedure or losing your job unexpectedly? One solution is to build an emergency fund before making any other investment.

The rule of thumb is to have three to six months of living expenses in a savings account at all times. When life happens, instead of pulling out the credit card or a home equity line, you will have a reserve fund to help you stay out of debt.

Develop a spending plan

Another technique is to develop a spending plan and stick to it. There are a number of free online resources that can help you budget and get a handle on your spending.

The bottom line: Even if borrowing makes economic sense, count the cost before you borrow and be in agreement with your spouse. Remember, consumptive borrowing likely will sentence one to a reduced lifestyle in the future and limit financial flexibility and freedom.

Loran Graham is a certified financial planner and member of the local Financial Planning Association chapter. Readers are invited to submit questions on financial planning to be answered in this space each Tuesday. Send questions to askaplanner@ spokesman.com.


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