Debunking Debt Misconceptions: Using Credit to Gain Financial Freedom
Debt can help you build a healthy financial future. This statement may seem counterintuitive, since popular convention would lead you to believe otherwise. But if you’re smart and disciplined about the way you use debt, it can actually help you improve your personal finances, build wealth and gain financial freedom.
Let’s look at five common misconceptions about debt, and why they should be debunked.
Misconception #1: Cash is always king.
Using cash can help you stick to a budget and develop better financial habits, but what it won’t do is help your credit score.
To build a strong credit score, you’ll need to establish a positive record that demonstrates you can handle debt – for example, making payments on time. Cash and debit card transactions aren’t reported to credit bureaus, which means that they can’t help your score. A higher credit score is important because it helps you qualify for loans with lower interest rates, saving you hundreds or even thousands of dollars in the long run.
But remember: Debt can also negatively impact your score. Making timely payments is a primary factor in determining your credit score, and a high debt load and high credit utilization ratio can knock points off your score. If you’re working toward financial freedom, only take on loans that you can afford and make your payments on time every month.
Misconception #2: All debt is bad.
Some debt can actually give you a return on your “investment” or help you make positive strides towards achieving other goals. There are instances where it can make sense to seek credit, you just have to be smart about it – only take on new debt if you really need it, pick a product that suits your needs, and know how you’re going to pay it off.
For example, there may come a time when you decide that it’s time to buy a house or a car, or maybe go back to school. With that in mind, a mortgage, auto loan or student loan could help you get the funds you need to make it happen. Or maybe you have a lot of high interest debt that you can refinance with a lower rate personal loan to save money.
But remember: when choosing the product that’s best for you, it’s vital that you understand the different features and what works best for your purpose. Ask yourself a few questions:
- What’s the total cost of the loan? Don’t get interest rate confused with APR. APR is the best number to use to know the total cost of your loan.
- Do I want to pay this off sooner than the terms state? If the answer might be yes, find out if you’ll get charged a pre-payment fee.
- Is this revolving debt or installment debt? The difference can impact how you manage your payment plan. Revolving debt can fluctuate while installment debt is best if you want fixed monthly payments that make budgeting easy.
- Is this a fixed or variable rate product? The difference can cost you a lot over the long run. With a fixed rate, you’re locked into a rate that won’t ever change, while variable rates can change over time.
Misconception #3: Mortgages are undesirable.
Buying a house may help you increase your net worth over time, and if property values rise, your home can be a potential source of retirement savings. When it comes to paying for that home, you may be tempted to put as much money down as possible to reduce the size of your mortgage–but that’s not always the smart move.
For one thing, home mortgage interest is deductible on your taxes, up to a certain amount. Interest rates on mortgages also tend to be much lower than those on credit cards. Instead of using the bulk of your cash to buy a home, it may make sense to keep some cash on hand to cover unexpected expenses, so you don’t resort to putting them on a high interest rate credit card.
Mortgages also have fixed monthly payments, which can help you stick to a budget and boost your credit score by making payments on time.
But remember: As the financial crisis taught us, real estate investments are never a sure bet, and home prices are not guaranteed to appreciate over time. Before taking out a mortgage, do your research, only purchase what you can afford, and work to improve your credit score so lenders will offer you an attractive interest rate.
Myth Misconception #4: There’s never a return on debt.
If you own a home, debt can be a tool to protect or increase the value of your property. You can also use debt to pay for home improvement projects, like replacing your windows or upgrading your kitchen, which may result in a higher price when you’re ready to sell.
But remember: Taking out a loan to fund a home improvement project that is not likely to add value to your home (like installing wall-to-wall carpet) is not a smart idea. Be judicious in using debt to make home improvements and invest in those projects that protect your property or may add value.
Misconception #5: Taking on more debt will bury you further into the debt hole.
Borrowing on a credit card has never been cheap, but it is becoming more expensive as the Federal Reserve hikes interest rates. The average rate on credit cards is 16.75%, up from 15.77% two years ago, according to Bankrate.com1. If you maintain a credit card balance, you are likely already paying higher minimum monthly payments and finance charges.
Getting a personal loan can be a great way to tackle mounting credit card debt. Personal loans often feature lower interest rates, enabling you to cut your monthly payments. Plus, they carry fixed rates—unlike the variable rates on credit cards—so you know how much you need to budget each month to pay your loan back. You can use your monthly savings to build your emergency fund or retirement account.
For example, let’s say you have a $5,000 balance on one credit card with an 18.9% annual percentage rate (APR) and a $10,000 balance on another card with a 19.3% APR. Assuming these rates never change, and you make minimum monthly payments of 4% on your outstanding balance, you’ll face a monthly payment of $600.
By taking out a personal loan of $15,000 with a 7.5% APR, your monthly payment would drop to $178.05. That’s $421.95 less each month than your current monthly credit card payments.
Checking your rate for a personal loan is fast and simple. It only takes minutes and doesn’t impact your credit score so it’s definitely worth a shot if you want to refinance or consolidate your debt.
But remember: Using a personal loan for credit card consolidation is only a good idea if it improves your financial situation. Personal loans come with a fixed term, so you have to repay the loan in a set timeframe. Ensure you can afford the monthly payment by understanding your budget and putting a solid plan in place to pay the loan on time. Also, review your loan’s annual percentage rate (APR), which will tell you the true cost of obtaining a loan.
Moving beyond debt misconceptions to build a solid financial future
To use debt to work toward gaining financial freedom, keep an eye on these two figures: your debt-to-income ratio (DTI) and your credit utilization ratio.
DTI measures how much debt you owe vs. how much income you earn, and many lenders use it to judge your ability to manage your monthly payments. While there isn’t a magic number, the lower you can keep your DTI, the better.
Credit utilization measures the balances you owe on your credit cards relative to the cards’ credit limits. If you never use your credit cards and there’s no balance on them, your credit utilization would be zero. If you typically carry a balance on one or more cards, you are ‘utilizing’ some of your available credit.
The general rule of thumb with credit utilization is to stay below 30 percent2. This applies to each individual card and your total credit utilization ratio. Anything higher than 30 percent can decrease your credit score and make lenders worry you will have trouble repaying new debt. This blog can help you calculate your credit utilization ratio.
Taking on debt requires careful consideration. You need to make all of your payments on time and in full to improve your financial picture. But, if you can stick to these parameters, it can be empowering to move past debt misconceptions and understand how you can use debt to find your financial freedom.
Learn more about developing financial habits that can help you improve your credit score and achieve your goals with Upgrade. Sign up for easy access to your free credit score and credit monitoring tools and get more credit tips at Credit Health Insights.