The thought of properly utilizing debt may appear to be a foreign and uncomfortable concept. Some people frown upon the idea of being indebted and prefer to make all purchases with the money they have. Others abuse debt and use it to fund lifestyles they cannot afford. Striking a balance between abuse and proper usage of debt is complex due to many factors. We will go over those factors and create a framework for proper debt usage.

WHAT ARE YOU PURCHASING?

For many, the disposable income left after each pay period is not enough to acquire major purchases. Debt is then relied upon to acquire items that are out of reach of our disposable income. Even if many of us saved a few checks, it may still not be enough to purchase a new car, a home, or a college degree. The average cost of a new car in the United States in 2024 is approximately $48,000. Most people do not have $48,000 of disposable income after each pay period to buy a car outright. The average used car cost in 2024 is around $24,000, which is also out of reach for the average American’s disposable income, which is $2500 per month.

When using debt to acquire an item that is out of reach of your disposable income, ensure that the item is essential and necessary. Avoid using debt to purchase wants or to fund a lifestyle above your means. A home can be considered a good use of debt because it provides shelter—a necessity—and it typically appreciates in value. A car fits the bill of necessity because it provides transportation. Even though reliable transportation is necessary, a car does not qualify as an appreciating asset. 

Depending on who you speak to, a college degree may not be considered a necessity, but many take on debt for a degree due to its future payoff. A degree can increase your earning power over your lifetime.

Debt is mainly used to acquire items that are out of reach of our periodic paychecks. Even if we make an effort to save several checks, many costly items will still be out of reach. 

IS DEBT THE BEST OPTION?

An item may be necessary and essential, but debt may not be the best option to acquire it. For example, a person may be driving an older car with substantial mileage and decide to save for a newer car. They may choose not to get a brand-new model and instead spend a few years saving for a used car that costs significantly less. Instead of using debt, a person may choose to save and buy used. This applies not only to cars but to any item. 

According to Susan Meyer’s article “New home vs. old home” on TheZebra.com, the median price of a new home is $355,400 compared to $240,500 for an older home. Keep in mind, it is essential to be informed when buying used. Whatever savings you achieve can easily disappear if the item is a lemon.

Another option is receiving gifts. Many kids’ first cars are gifts from parents or family. Down payments for homes, wedding costs, furniture, vacations, and even college degrees are often gifted by family. There are many cases where parents give money for their children to start a business or pursue a non-traditional career.

DETERMINE HOW MUCH DEBT TO USE

A major part of using debt strategically is deciding how much debt to take on. This depends on the item and personal comfort level. For purchases like a house, the lender determines how much the borrower must put down as a down payment to qualify for the loan. Down payments can be as low as 5% or as high as 20%. There are no rules stating you cannot put down more. Keep in mind: the higher the down payment, the less you pay back over the life of the loan.

DETERMINE THE COSTS AND STIPULATIONS

Loans come with costs and stipulations. One important cost is the interest rate. Depending on your creditworthiness, the interest can be low or very high. If your credit is not in the best shape, it is best to improve it before taking on significant debt. The difference between a fair credit score and a good one can amount to thousands of dollars over the life of a loan.

Another cost to look out for are fees. Fees vary greatly from one lender to another. As a borrower, you should shop around for the best deal with the most reasonable fees. Also, be aware of costs outside the listing price. You may be able to roll closing costs into a home loan, but inspections usually are not covered. The same applies to vehicles—having a third-party inspection done is not covered by an auto loan.

There are also costs associated with simply searching for the right item, such as missing days of work or hiring an agent.

When shopping for a loan, be aware of stipulations. Some lenders require stricter conditions such as income source, duration of employment, income range minimums, credit score minimums, and down payment minimums. The best loan for you is the one with the most favorable stipulations for your situation. Also keep in mind that there are exceptions based on individual circumstances. For example, certain loans do not require down payments for veterans. Make an effort to be informed about all stipulations that may benefit you.

SOURCES OF CREDIT AVAILABLE TO YOU

Your financial state and creditworthiness heavily influence the sources of debt available to you. Not all lenders are created equally. Some are predatory and will take advantage of desperate borrowers. High interest rates, unnecessary fees, and unfavorable terms are just a few ways predatory lenders operate. Ensure that before you go shopping for a loan, you are in the best financial and credit position possible so you have access to better options. 

RATIOS

Do not be intimidated by ratios. They are important tools for ensuring you are not overleveraged. Ratios simply compare two numbers. They act as measuring sticks for your financial state. We will cover a few important ones related to borrowing money.

Debt-to-Asset Ratio

This ratio shows how much debt you have compared to your assets—or how much debt you will have compared to your assets if you take on additional debt. 

Formula: 

Total Debt / Total Assets = Debt-to-Asset Ratio

Example: 

Total Debt: $50,000

Total Assets: $200,000

Calculation: $50,000 / $200,000 = 0.25 or 0.25 X 100% = 25%

The 0.25 or 25% represent the portion of your assets funded by debt. Lenders often view 0.3 or 30% as ideal. In extreme cases, a person’s debt-to-asset ratio may exceed 0.6 or 60%, meaning the majority of their assets are funded by debt. If they liquidated everything, they would still not be able to pay off their debt.

Debt-to-Income Ratio

This ratio compares a person’s monthly debt payments to their gross monthly income.

Formula:

Total Monthly Debt / Gross Monthly Income

Example:

Total Monthly Debt: $2,200

Gross Monthly Income: $5,100

Calculation: $2,200 / $5,100 = 0.43 or 43%

Lenders also consider this ratio when determining creditworthiness. A ratio of 0.36 or 36% is considered healthy. The example of 0.43 or 43% is high, meaning nearly half of their income is going toward debt payments. 

DESIGN YOUR PAYMENT PLAN

Many borrowers make the mistake of using the maximum amount they are qualified for. This is a mistake because what you are qualified for may not be what you need. Lenders are in the business of selling and are incentivized to encourage you to borrow as much as possible. This benefits them—not you. For example, you may have high income and low debt, qualifying you for a million dollar home. But a home in the $200,000 to $300,000 range may meet all your needs. This applies to cars and other purchases as well.

Taking the maximum loan amount even when unnecessary leaves you with fewer options for future purchases and creates risk in the event of income loss. 

NEGOTIATE

A savvy buyer knows everything is negotiable. There is no law that states that you cannot negotiate the sale price, the interest rate, or the fees and terms of a loan. Negotiation is far more effective when done from a position of strength, which is why having good credit and solid financial health is important. Social stigma is one of the biggest reasons many people never attempt to negotiate a better deal.

PARTNERSHIPS

If the ownership and benefit of an item being purchased with debt will be shared by two or more individuals, splitting debt responsibility can be beneficial. This is common when purchasing homes where spouses, partners, or family members share mortgage payments. The benefits include a higher likelihood of loan approval, lower payments because they are shared, and covered if one person cannot make payments. However, having multiple people can also be a disadvantage if the loan is barely manageable even with all members contributing. Ideally, remaining members should be capable of covering the payments if one loses income. 

CREATE SAFEGUARDS TO YOUR PAYMENT PLAN

Most people rely on job income to repay loans. In cases of unemployment or reduced income, safeguards such as emergency savings can keep payments uninterrupted. This is why it is important to take out manageable loans. An unmanageable loan may wipe out your savings quickly during hardship.

PROTECT YOUR ITEM AND PURSUIT

There are many ways to protect the items that you are purchasing, especially those you are acquiring with debt. In the event that your item is damaged beyond use, you may still be on the hook for the remaining loan amount and the cost of replacing the item. Proper insurance protects you from this risk.

Another way to protect your item is doing proper due diligence before purchase. This goes for all purchases, not only those being acquired by debt. It is especially crucial for expensive items like homes, cars, and education programs. You do not want to spend years pursuing a degree only to learn the institution is unaccredited or fraudulent. Loss of time, energy, and money—plus the responsibility of repayment—can be devastating.

KEEP PERSONAL AND BUSINESS DEBT SEPARATE

Entrepreneurs will often ignore this suggestion due to their creativity in seeking funding. For everyone else, keep personal debt and business debt separate. Even if you choose to ignore this, make an effort to keep separate and clear records. Mixing personal and business expenses can lead to IRS audit failures and tax liabilities.

Another risk of using personal debt to pursue business ventures is that you put your personal assets at risk. Taking out a second mortgage to start a business that fails, could result in losing your home.

FINAL THOUGHT

Debt is a part of all our lives and an integral part of our financial system. Some preach that debt is bad, but this is not true. Debt is neither good nor bad—it is a useful tool. When used correctly, it can help us acquire necessary items and pursue educational goals. 

However, improper use of debt can lead to financial ruin:

—using credit cards to buy a lifestyle your income cannot support 

—borrowing more than you need

—borrowing when desperate and vulnerable to predatory lenders

—failing to do due diligence

—being poorly insured 

Avoiding these pitfalls allows you to take full advantage of debt and improves your chances of achieving your financial goals.