With so many options for credit cards, personal loans or even buy now, pay later apps, it can be tough to know when it’s the right time for taking on debt. Before you decide whether to start saving up or break it into installment payments that may include interest, here are eight questions to ask yourself.
1. Could I realistically pay in cash instead?
While debt can get an unfair rep sometimes, there are benefits to utilizing credit – otherwise called taking on debt - as long as it’s done responsibly. That said, in many cases it can be financially advantageous if you can buy something outright instead of financing it.
You should always determine what amount, if any, you can pay in cash and where that leaves your savings. Because you do have money in savings, right? If not, make sure you’re doing that, too, because it’s equally important for your overall financial health.
In some cases, you may be surprised to discover you can avoid taking out a loan and still have a bit of a financial safety net left over. In other cases, paying in cash simply isn’t feasible. Just as I recommend paying in cash over credit when possible, I also recommend never completely draining your savings for a purchase, either.
2. What type of monthly payment can my household afford?
This is an important question not just from a budgeting perspective, but to make sure you aren’t getting in over your head with payments.
Calculate the amount your household has available to spend each month - after bills, expenses, and savings contributions - and then see what payment would be realistic. Keep this dollar amount in the forefront of your mind throughout the process of exploring loans and other credit options.
Once you have shopped for the best available terms and rates, calculate what your payment would be and see which most closely aligns with your expected budget.
3. Will the life of the item outlive the term of the loan?
Some expenses, such as the purchase of a home, are often necessary to finance but can be thought of more as an investment. If your mortgage payments are a reasonable amount and you can sell your home for more than you purchased it, that’s typically well worth it.
On the other hand, splurging for the newest, most expensive vehicle you can find isn’t always best. Auto loan terms typically range anywhere from 24-72 months and your vehicle’s value begins to depreciate the moment you drive it off the lot.
Without purchasing extra coverage such as GAP insurance or warranties, if your vehicle were to die over the course of your repayment period, you can easily get in over your head paying for something you can’t even drive.
4. What is the best type of debt for my needs?
When the time comes to make a purchase, don’t jump on the first thing you see when it comes to financing.
There are advantages and drawbacks to anything, and that includes credit purchases. One situation might be best suited for something like a home equity line of credit, whereas you might better benefit from a personal loan or credit card for other things.
Many credit card companies offer specials like 0% interest for a specific amount of time, which can be quite helpful. Just remember – interest kicks in after the period ends and it’s always best to make timely, full payments to avoid serious fees.
5. Will going into debt now hurt or help later on?
There’s a necessary distinction between a “need” and a “want,” and it’s wise to place potential purchases into one of the two categories before going into debt over them.
If your car is 10 years old and the engine dies, a new vehicle may be a need for your household. On the other hand, the latest gaming console probably isn’t worth purchasing on credit and can more realistically be paid with savings.
There is also a distinction between “good” and “bad” debt. Good debt can be thought of as anything that will increase in value, thus increasing your net worth, or will substantially enhance your life.
Bad debt, on the other hand, can be thought of as anything you go into debt over that will rapidly depreciate or merely provides short-term, temporary entertainment or use.
6. How will this affect my credit?
Making payments on time and in-full is a great way to build your credit, boost your score, and show any future lenders how reliable you are with finances. At the same time, missing payments or accruing interest can cause you to get into a costly hole and hurt your credit score, along with your chances of getting credit approval in the future.
7. Have I put thought into this decision?
There’s a reason stores put candy, magazines, trinkets, and other items to catch your eye right by the register on your way out – impulse buying is very real.
Unlike that $0.99 pack of gum, however, larger purchases have a greater impact on your finances. Make sure any large purchase, especially one you’re considering financing, has been well thought-out before committing to it.
8. What happens if my financial situation changes?
You should absolutely ask yourself if the loan or credit product you land on is one you would still be able to pay if your financial situation were to change in any way.
It’s an uncomfortable thought, but factoring in things such as inflation or job loss are important, realistic things to consider when going into debt and figuring out what you can afford over the course of the repayment period. While this goes for anyone, this is an especially important question for individuals or single-income households.
All of these tips involve a significant amount of calculating and planning. To make it easier, there are multiple calculators listed below this article that can help.
OMB and its affiliates do not provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decision.
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