Most people don’t have the ability to pay for their next car or home all in cash. So debt is the tool we use to get things like this, that we can’t pay for all up front. The catch is that we have to pay extra money to the person or company we’re borrowing money from (the lender). This is because the lender doesn’t know if you will pay them back. So they require you to pay a little extra to balance out their risk. Easy!
The game for lenders is to find the right people to lend money to, so they end up making money on their loans, instead of giving money to people who won’t pay them back.
This is where someone’s credit score comes in. A credit score simply represents a person’s financial reputation: The better their reputation, the more likely they will get a good loan, with a lower interest rate. Learn more about credit scores and how they are calculated here.
Debt can be very convenient, especially when using credit cards, but it’s something you have to be careful with. Although debt is the only way you can build your financial reputation, it’s also the only way you can destroy that reputation. And if you destroy your financial reputation, like trust, it’s very hard to rebuild.
So, if you plan on buying a home or a car at any point in your life, your financial reputation is important. It directly impacts the interest rateThe interest rate for a loan or credit card determines how much you pay in addition to what you borrow. that you get for these loans, or whether you are able to get a loan at all.
Take this as an example. You know at some point in the future you would like to buy a house, but as you’re paging through shoes on Ebay, you find the pair of Jimmy Choo pumps that you’ve always wanted. You buy them on your brand new credit card for $500, and pay the minimum on the card until it’s paid off (3.5 years later). Never spending anything else on the card.
You might think, “Ok. Fine. It took almost 4 years to pay off the shoes, and I ended up spending an extra $185 because of interest. But, no big deal!”
It is a big deal though… Those shoes will actually end up costing you more than $88,000!
“Ok. Wait a minute.. How did you get that?”
Unfortunately, paying only the minimum for that long on a credit card can reduce your credit score significantly (upwards of 200 points).1 So, when you get a mortgage to buy your house, the interest rate will increase by about 2% in this case, because of your poor credit score. That increase in interest over the life of the loan will end up costing you an extra $88,000!
Play with the tool below to see how changing your interest rate impacts how much you end up paying for a loan.
Sometimes the things we need, like homes or cars, are too expensive for us to pay for all at once. In order to be able to buy these things, we need to show lenders that giving us a loan isn’t risky. And the only way to do that is by showing them examples of us successfully paying off debts in the past.
This means that you need debt to get approved for more debt! Interesting, right?
Based on what we’ve learned, debt can be both “good” and “bad”. And you need to have had a history of good debts in order to be approved for bigger loans, like for cars or homes.
Interestingly, student loans and credit cards are some of the best ways to build a good financial reputation, as long as they’re being paid off on-time. But, as with the example about the Jimmy Choo’s, credit card debt can really hurt your reputation if you buy things you can’t pay off right away.
So... to debt or not to debt?
It really depends.
As long as the debts you take on are “good” debts that improve your financial reputation, then you’ll be alright. It’s when “bad” debts creep into your life that things can get off track.
To learn how to spot the differences between good and bad debts read our next article.
Although making payments towards your debts is always a good habit to get into, it isn't necessarily the most fun. We think that living the life you want to live both now and in the future (while still making payments towards your debt) is a lot more fun! This is something that personalized lifestyle planning can help with.
At Previsio we understand the whole picture of your financial life, and work with you to make plans specific to your wants and needs. No need to worry if you’re spending too much, or not saving enough to achieve your goals. We'll take the guesswork out of it. Sound like a good deal?