Imagine your life without debt. Pretty good, right? But how would you pay for a house, a car or your children's college tuition? Debt-free living is a nice ideal, but for most of us, it's not very attainable.
The issue, then, is to make sure the debts we have are "good" debts. For a debt to be a good debt, it has to meet three rules.
Rule 1: Before entering into any credit arrangement, you must carefully consider your financial condition, which you won't know unless your finances are under control with a good spending plan. And don't count on future income. Too many families overextend themselves by spending future income that never arrives or ends up being needed for something unanticipated. Be conservative when making assumptions about your ability to pay on your debts. A good measurement is that your total monthly debt payments should be less than one-third of your monthly gross income.
Rule 2: There should be a reasonable opportunity to recover the principle and interest of a debt at a future date. Although nothing is ever guaranteed, there are four ways that borrowed money can be recovered:
But don't forget that rule one still applies! Even good debts must be affordable based upon your financial condition. The recent economic downturn is a good reminder to be cautious about future financial expectations.
Rule 3: Good debt should not tie up too much future income, even if it is affordable today. An otherwise good debt, according to rules one and two, can become bad when it ties up resources that are needed later for other things. The best way to be ready for future expenditures is to prepare today by saving money rather than borrowing it.
Under these three rules, most consumer debt is not good. And even if you have good debts, it's still wise to minimize all debts, not just the bad ones. Before you take out the credit card or sign loan papers, remember that you're about to spend tomorrow's paycheck, and when tomorrow comes, yesterday's purchase probably won't feel so great. So the best debt of all still may be the one you avoid.
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