The Thoughtful Borrowing Basics to Stay Financially Fit
Borrowing for the first time is a big financial milestone — whether that's taking out a student loan for college, buying a home, starting your own business, or getting a new car. It's worth becoming informed about the do's and don'ts of thoughtful borrowing so that you feel confident in your decision to borrow. You should feel secure knowing that your loan or line of credit is helping you work toward your goals without jeopardizing your financial security.
Good Debt vs. Bad Debt
Ideally, one should only take on good debt. Good debt builds financial wellness and helps you meet a need or reach a goal while still fitting into your budget. An example of good debt is when someone takes out an auto loan to buy a car that they will drive to work. This debt allows the borrower to access needed transportation and meet goals like succeeding at their career and earning income. As long as the loan was appropriately budgeted for, the borrower can make payments on time without any disruption to their finances.
Bad debt, on the other hand, does not help you reach a goal. It can put a strain on your budget, and/or detract from your financial well-being. An example of bad debt is charging purchases to a high-interest credit card without a clear purpose or good reason for spending and without thinking about whether payments would be affordable.
There are no set rules for distinguishing good debt from bad, and debt that's good for one person might be bad for another. The best way to ensure that you only take on good debt is to think about your goals, the pros and cons of borrowing, and the long-term cost of the debt before you decide to borrow.
Setting Goals for Borrowing
Write down your goal and reasoning for borrowing money. Usually, this is something you want to purchase like a car or home or a bill you want to pay. Then, ask yourself a few questions:
- Is This a Short-Term or Long-Term Goal? Long-term borrowing is best used to pay for things that you'll benefit from over several months or years. For example, you might take out a home improvement loan to build a deck that your family will enjoy for decades. A short-term goal is something that you can accomplish within a few days or weeks such as a much-needed vacation.
- Is This a Want or a Need? Needs depend on your personal values and priorities, and they generally include things like health, safety, food, shelter, transportation, education, a job, and spending time with family. Wants are things that are "just for fun," or that you could forgo without sacrificing your well-being.
- Is This a Goal You Could Save for? Saving up for a goal has an advantage over borrowing in that you don't have to pay interest. Saving makes sense for most wants, small purchases where it's easy to cover the cost, and upcoming items that are easy to predict and plan for.
- Are You Comfortable Borrowing for This Goal? This is a personal preference, and there's no one right answer for everyone. Some people feel good about borrowing, and others try not to borrow unless they absolutely have to.
- How Does This Goal Contribute to Your Financial Security? A loan to start a small business can empower you to embark on a new career and grow your income. Loans can help pay for a medical procedure to help you stay healthy so that you can continue to provide for your family. You can also make strides towards paying down debt by consolidating your loans.
- What Are the Trade-offs? Borrowing can help you maintain a stable budget with fixed monthly payments, allowing you to stay on track with savings goals or retirement plan contributions. If your retirement investments earn a higher rate of return than the interest rate you're paying, then you can come out ahead financially.
Know the Main Types of Credit
Credit comes in two main forms: installment and revolving credit. With installment credit, you borrow a specific amount of money and then pay it off with a fixed number of payments. Once it's fully paid off, the account closes. Mortgages, auto loans, and personal loans can all be in this category. Installment loans are well-suited for long-term needs or big purchases that you make only once.
Revolving credit includes credit cards and home equity lines of credit, and preferred lines of credit. With revolving credit, you borrow money up to a limit, pay it back, and continue borrowing and repaying as long as you don't exceed the limit. Revolving credit is useful for repeat purchases and continuous expenditures. You may decide to put some recurring expenses like a gym membership and a video streaming subscription on a credit card. You might also use a line of credit to repair and upgrade equipment for your small business if that's something that needs to be done on a regular basis.
Keep in mind that borrowing has a cost: the interest that you pay. Use a calculator to compare the costs of different loans and to explore your options. Then make sure that those payments work within your budget.
Thoughtful Borrowing Builds Credit
Maintaining a good credit history and credit score is important because lenders look at this information before they issue credit. A high credit score can mean that you're eligible for better interest rates, loan terms, and credit card perks. Borrowing and making payments on time boosts your credit score in several ways. It establishes that you pay back debts responsibly and creates a record of on-time payments. It increases the number of accounts you have open and in good standing — which is a plus for your score. And if you use about a third or less of the credit that's available to you, it's also a win for your credit usage rate. For these reasons, it's usually a good idea to keep revolving credit accounts open even if you don't have an immediate need to borrow from them.
Making an informed borrowing decision depends on many factors, and it's important to look at the specifics of your finances before borrowing. Getting input from someone who's knowledgeable about borrowing options and who can objectively review your financial situation is a great first step. You can always reach out to a KeyBank lending specialist to talk through what option is best for you.