by Ken Spitze

Created on: March 17, 2009

Fundamentally, debt is caused by buying something that you think you need now, and paying for it later. For this, the debtor pays interest. So, is debt bad? Well, that is certainly a matter of opinion. Let's examine some types of debt and see what exactly are the costs and benefits.

What if I wanted to buy a new sofa and don't have the money. I could borrow money and buy it now and then use it while I'm paying for it. Suppose the sofa costs $540 and I buy it, agreeing to pay 10% annual interest over two years. I'd make monthly payments of about $25. I'll get the sofa today, but instead of paying $540 for it, I'll pay about $600 including interest.

What else might I do? Well, I could make do with my old sofa for those two years, and instead of making payments on the debt, I could save the $25 and put it into an interest-earning account. Suppose I could get 3% interest. At the end of the two years, I'd have about $620. Then I could buy the sofa with cash and have $80 left for my next purchase.

You will always get more for your money if you save, earn interest, and pay cash. But, does this mean that you should always wait to make purchases? Well, perhaps not. Let's look at buying a house. Such a purchase using debt is called an asset-back debt. You are "buying" the house, but actually the bank owns it until you pay off the loan. But, along the way, you are accumulating "equity" in the house. That is, you own part of it, so that if you sell it, some of the price you receive will go back into your pocket.

So, what is the difference between the sofa purchase and the house purchase, both using debt? One thing to consider is need. You need to have a place to live. If you don't buy a house and go into debt, you'll pay rent. For the rent you'll get the use of that house, but you won't accumulate any equity. If you buy the house, you'll be making payments. Each payment will consist of several parts: some of it will be interest on the loan, some of it will go to house insurance, some will go to taxes, and some will be equity that you slowly begin to accumulate in the house.

Is it best to save and pay cash or buy and go into debt? There is no "correct" answer. But, you have to live somewhere. If you rent, you have only the use of the house. If you buy, you will accumulate some equity. If your total house payment is the same as the rent you would pay for a comparable house, then you will come out ahead if you buy and take on a mortgage.

These are two extreme examples. The sofa is not as necessary as the house. You can get by with a cheap sofa you get at a yard sale until you can save enough to buy a nice one. It is reasonable to wait two years for the nicer sofa. However, you might have to save for 20 or more years in order to buy the house. All that time, you are paying rent, so the amount you can save might be very limited. A prudent house purchase may make more sense.

The danger in all of this is the fact that you can buy "more" on credit. If you start looking at housing with an agent, I can almost guarantee that the person will try to convince you to buy a more expensive home that you had envisioned. "You can afford more", will be the undertone of the pitch.

The bottom line is to be careful when using debt, but also don't be terrified of it. Used carefully and wisely, it can add to the quality of your life. But be careful when housing prices go up rapidly, it is possible to pay too much for a house and be stuck with high payments for a house that is no longer worth it. This has happened to many people in the years leading up to the housing problem that exists here in the late 2000s.

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