Exploring the Role of Loans in Personal Finance

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It’s easy to fall for the assumption that there are two camps of people: (1) those who love loans and use them all the time, and (2) those who are adamantly against loans and won’t use debt under any circumstances. But the smartest financial plays generally take place in between these two extremes.

Two Types of Loans

Before we can dig into some of the specific situations and factors that justify the use of loans in personal finance, it’s necessary to set the table, so to speak. In order to have a reasonable discussion on the topic, we must clarify that there are two major types of loans: secured and unsecured.

When you take out a secured loan, you have to offer the creditor something as collateral. This is often a valuable tangible asset – such as a home or car – but can also be a savings account or other financial instrument. If you don’t repay the loan, then the lender is able to initiate a process through which they take the collateral as repayment.

With an unsecured loan, there is no collateral securing the loan. Though the creditor can choose to sue you and take money out of your paycheck or bank account, there’s no asset directly tied to the loan. As a result, these loans typically come with stricter requirements and higher interest rates.

Furthermore, under each of these headings, there are fixed- and variable-rate loans. The former have a fixed interest rate from start to finish, while the latter can adjust over the life of the loan.

When Debt Makes Sense

Many people struggle with knowing when to use debt and when to avoid it. Admittedly, it isn’t always black and white. However, there are some factors and situations that make debt a useful instrument. Take a look:

  • Opportunity to Own an Appreciating Asset
  • Low Debt-to-Income Ratio
  • Low Interest Rate
  • Insurance Against Unpredictable Events

Debt is best used when there’s an appreciating asset in play. In other words, you want to take on debt when the underlying asset has an opportunity to increase in value. An example would be a home or other piece of real estate. In these situations, you’re using someone else’s money to make an investment that can yield a return.

Every person has a debt-to-income ratio. This tells you (and lenders) what percentage of your income goes toward debt payments. Calculating your own is pretty easy.

“Take the sum of your total monthly debts and divide it by your pre-tax monthly income. Then multiply by 100 to get your percentage,” Credit Loan explains. “Ideally, you want your debt-to-income ratio to be 36% or less.”

If you currently have a debt-to-income ratio that’s well below this 36 percent threshold, then you have room to take on more debt. Should you encounter a situation where you need it, you can rest easy knowing you’re in the safe zone.

Most people see a low interest rate and immediately jump. You don’t want to be quite so hasty, but it’s a factor worth considering.

Every now and then, you’ll see lenders use promotions like “interest-free for 36 months” or “1-percent interest for the first year.” Depending on the type of loan and your current debt situation, this may present an opportunity for shuffling your finances and saving money in another area.

Some people find certain types of debt act as unofficial insurance policies. This is the case for entrepreneurs like Miranda Marquit.

“My bank, where I keep my primary checking account and my business checking account, allows me a personal line of credit,” Marquit explains. “This is actually a revolving line of credit that is a little bit different than the more traditional personal loan. This personal line of credithelps me smooth my cash flowwhen clients pay late or if I have other issues arise.”

Practicing Discipline and Discretion

Loans – both of the secured and unsecured variety – are useful in personal finance. And while it has a place, it shouldn’t be abused or relied on too heavily. Sustainable financial success is all about discipline and discretion. Balance is also a key piece to the puzzle.

As you consider using debt to accomplish personal finance goals, take the time to perform adequate due diligence and careful strategic planning. Your finances will follow you for the rest of your life. Don’t ignore this issue!

DISCLOSURE: None


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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