An article in The Wall Street Journal (9-16-07) had the following to say about the use of credit: “When it comes to building wealth, saving and smart investing get the most ink.  But understanding how to manage your debt can be even more important to your financial future.”

So, what can you do to wisely manage your use of credit?  Let’s first consider common reasons why people incur debt.  [Note: When we use the term “incur debt,” we are referring to any situation in which the use of credit will result in having a debt that won’t be completely paid by the end of the grace period during which interest charges won’t be incurred if the balance is paid in full.]

Probably the primary reason why many people in our society go into debt is because of their desire for instant gratification.   In order to purchase things sooner than if they were to wait until they have saved enough money to make the purchases, people are willing to go into debt to immediately get what they desire.   In essence, they want to enjoy a standard of living for which they would otherwise need to wait before they could afford it.

Ron Blue, a prominent Christian writer and lecturer on family financial matters, says on page 59 of his book entitled Master Your Money,

[D]ebt always mortgages the future.  The first priority use of future income must be debt repayment. . . The freedom of choice disappears.

Current marketplace wisdom says to you ‘Raise your standard of living by buying what you want and pay for it while you enjoy it,’ but the reality is that you may be sentencing yourself to a lower standard of living in the future.

By borrowing to make a purchase and then paying only the minimum amount that is required each month, a person may be paying roughly three times as much as the cash price.  Assume, for example, that a person pays an interest rate of about 18% to 20% on their credit cards and that they pay just the minimum amount that is required each month. By the time the balance is fully paid, they will have paid approximately three dollars for each dollar that they charged.

People may think that going into debt will raise their standard of living, but over a period of years the interest charges will steadily reduce their ability to maintain their standard of living.

A second reason why people go into debt is because they believe they will receive a big benefit from claiming an income tax deduction for the interest paid on certain types of loans.  But, even if the interest is deductible, it will not be as beneficial as you may think.  For instance, if you pay a combined federal and state income tax rate of about 33% for each additional dollar of taxable income, you will reduce your taxes no more than $33 for every $100 you pay in interest, assuming it is worthwhile for you to itemize rather than take a standard deduction.  In other words, you will be paying about three dollars of interest for every one dollar by which you may be able to reduce your income taxes.  And, if your combined income tax rate is close to 20%, you will be able to reduce your taxes by no more than $20 for every $100 you pay in interest.

A third reason why people go into debt is to avoid reducing their existing savings.  However, by borrowing rather than using existing savings to pay with cash, you are almost certain to have less future savings than if you used the savings to pay down the debt faster.  This is because the costs of borrowing are almost always substantially higher than the rates that can be earned on savings.  You don’t increase your wealth by paying 18% – and perhaps even more – on a debt while earning 3% or less on a savings account.

A fourth reason why people go into debt is to purchase items while they are on sale or before the prices of the items increase.  However, even if there is a large discount on an item, it may not be prudent to incur debt to purchase it.  For example, to justify the cost of using a credit card that charges interest at an annual percentage rate of 18%, you would need to realize a saving of more than 18% off the usual cost of the item, assuming you take two years or longer to completely pay the balance of the purchase price.  And, the more time it takes you to pay off the balance of the purchase price, the greater the discount will need to be for you to realize a benefit from the sale.

Now that we have considered several common imprudent reasons for incurring debt, let’s consider a few reasons that make more sense.  But, keep in mind that almost all your debts should be completely paid as soon as possible in order to limit the damage to your long-term standard of living.

Incurring debt may be practical when it will enable a person to increase their earning power.   For example, a student loan may enable a person to prepare for a job that will significantly increase their earning power. Another example is a loan for a car that is necessary to get a job or to get a better-paying job.

Incurring debt isn’t imprudent if a person can borrow at a lower interest rate than the rate of return they are assured of earning on an investment.  However, if there is uncertainty regarding either the return of the principal amount that will be invested or the earnings expected from the investment, incurring debt in such a situation would be risky and, therefore, imprudent.

Incurring debt when there is an emergency may be reasonable.  One such situation would be to pay the costs of visiting a seriously ill relative who lives a great distance away.  Another such situation would be to pay the costs of major repairs for your car.  But, it would be wiser to build an emergency savings fund in advance to pay for such emergencies.

It is important to keep in mind that when credit is not used carefully, it often causes serious family problems.

1.  Using credit does not eliminate financial problems that arise when spending exceeds income.  Instead, using credit delays dealing with those problems, thus allowing the problems to get worse.

2.  Excessive use of credit will reduce the amount of money that is available to pay for necessities.  And, the longer a family continues to spend beyond its means, the more their economic future will be endangered.

3.  If you can’t make the required payments, your credit record will be blemished for several years.  Delinquencies will remain on your credit record for seven years, and if you declare full bankruptcy(i.e., Chapter 7), it will stay on your credit record for 10 years.

4.   Worst of all, excessive credit use can cause severe financial tensions that may wreck a marriage.

Before you make a decision to incur debt for any reason, ask yourself the following questions, in addition to applicable scripture-based questions (see our article entitled “OK To Use Credit?”):

1.  Do I need to make the purchase now or can I postpone the purchase until I have the cash?

2.  What will be the total cost of using credit, and am I both willing and able to pay the cost?  To answer this question, consider the following:

  • Am I sufficiently confident that I won’t lose my job or have a significant reduction in my pay before the debt is entirely paid?
  • Can I make the monthly payments on the debt out of my current income and still have more than enough money left to meet my family’s necessary expenses?  Keep in mind that your ability to make debt payments will decrease if the prices of food and other necessities increase faster than your income.

One “rule of thumb” has been that not more than 15% of aftertax income should be used to make credit payments, excluding the mortgage payment.  However, the merits of any rule of thumb are questioned in a Wall Street Journal article (12-10-93), which stated,

Financial advisors generally avoid rules of thumb, such as a percentage of monthly income that can go to service debt.

[E]ven 10% of net income may be too much for folks whose other expenses are high.