The Smart Ways to Go Into Debt

You’ve been warned about the evils of debt, and there is plenty to be wary of. But debt isn’t always bad.

“There’s a difference between good debt and bad debt,” says attorney Garrett Sutton, founder of CorporateDirect.com. “Bad debt takes things out of your pocket; good debt puts money in your pocket.” For example, he says if you leverage a loan to buy an apartment building, you can benefit from appreciation and depreciation while you are paying back the loan, and someday own an income-producing asset free and clear.

Sometimes, though, it’s not that clear-cut. Using a credit card to put gas in the car while you look for work may seem like a bad way to go into debt, but whether that proves to be true in the long run depends on how those interviews pan out. And the debt you took on to go back to school to pursue your dream can either feel like the best — or worst — decision you ever made.

Here are some guidelines for borrowing when the lines between good debt and bad debt are blurred.

Know the Numbers

Planning for debt is better than going in blindly. When you do, here are some helpful numbers to know before you borrow.

1. What Will It Cost? Planning on pulling out the plastic? Make a list of all your cards and their interest rates. Check with each issuer to see if they offer low-rate balance transfers. Your goal should be to borrow as cheaply as possible.

2. What Are Your Limits? Also know your credit limits on each account as well as your current balances. Your goal should be to try to use no more than 25% of any of your credit limits since balances above that amount may start to hurt your credit scores.

3. How Are Your Scores? It’s also helpful to check your credit scores before you need to borrow. That way you’ll know whether it’s possible to get a low-rate loan, and if there are action steps you can take to improve your credit in advance.

Here are some special situations that may require you to take on debt and how to navigate these scenarios the best you can when…

If You Are Unemployed

In the 2014 Credit.com American Dream survey, slightly more than 40% of respondents said they said they had been unemployed at least once in the past three years. Of that group, 28% said they had been unemployed more than once, and 60% said they were out of work for more than a year.

Losing your job can throw your personal economy into a tailspin. If you’re lucky, you may be able to collect unemployment — here’s a guide to getting unemployment benefits — and have some savings to fall back upon while you job hunt. But if those funds don’t stretch far enough, you may find yourself turning to credit cards or other loans just to put gas in the tank or food on the table. Getting a loan at anything near a decent rate is going to be nearly impossible if you are unemployed, so in many cases you will have to work with the credit you already have.

If you have a choice, unsecured debt (like credit cards) is preferable to secured debt (such as home equity or a car title loan) because if you have trouble paying the loan back you are less likely to put your collateral (home, car) at risk.

Borrowing may also be preferable to withdrawing money from your retirement accounts. The problem with tapping your retirement funds is that you will often pay taxes as well as an early withdrawal penalty (if you are younger than age 59½). That means right off the bat the IRS gets a good chunk of your retirement savings — money you’ll likely need when you are no longer working. Here’s a helpful calculator to help you estimate the cost of 401k early withdrawals.

If You Are Starting a Business

Launching a business often requires capital and if you don’t have it, you may find yourself looking for a loan. Unfortunately loans for brand new businesses are often very hard to come by. That’s why entrepreneurs may cobble together funding from their personal credit cards, home equity loans, or loans from friends and family.

Mitchell Weiss, a former financial services executive and author of Business Happens, has more than thirty years of experience in lending. “One of the top five reasons why businesses fail,” he says, “is because they didn’t have a liquidity facility in place — a go-to source of funding — if business doesn’t ramp up as fast as they expected or there is a seasonality factor that they weren’t aware of.”

He goes onto explain, “That could either take the form of a line of credit at a bank, or a credit card with plenty of availability to spare. For small businesses, a consumer credit has far superior consumer protections than business credit cards – just take care to keep a record of the business-related charges you make and to pay off your balances on time.”

Another concern entrepreneurs should keep in mind is their how these loans may affect their own credit ratings. Ask the lender whether these loans will be reported on your personal credit reports, and if so, keep in mind that any debt you accumulate may affect your personal credit scores.

If Your Family Is Expanding

A new baby or an aging parent that moves in with you can put a huge strain on your budget, and even more so if you have to take a pay cut in order to take care of them. While caregivers often make huge sacrifices in these situations, it is helpful to try to be as objective as you can about distinguishing between needs and wants.

When my daughter was an infant, I threw money at gadgets and tools that promised to help her sleep better. A soothing music tape? Gotta have it. A special crib mattress designed to be more comfortable? Let’s try it! (I fantasized about a motorized car for my living room that would go around in circles, since the car seemed to help her sleep but didn’t let me rest. I would have gladly gone into debt for something like that.) None of them worked.

But I also wasn’t shy about taking hand-me down clothing from friends and relatives, or shopping at garage sales. Many of the items I acquired had been previously used by other parents and that helped even things out.

When you’re in the midst of a major life change, try to borrow cautiously and try to stick to low-rate loans whenever possible. A credit card with a low interest rate may be your safest bet, but the minimum payments can allow you to quickly rack up more debt than you realize. So keep an eye on the 3-year payment number on your statement. If that number starts getting too high, you may need to reach out to a credit counseling agency for a free consultation to see if they can help you develop a budget that works.

If You’re Going to College

Whether you are a high school grad heading straight off to university, or someone heading back to school for a degree to enhance your career prospects, student loan debt can seem inevitable. And sometimes it is the only way to get through college. Before you blindly take on debt, however, make sure you educate yourself on how student loans work — your school probably won’t. Use the “net price calculator” you’ll find on your prospective school’s website to learn more about costs and financial aid. And be sure you fill out the Free Application for Federal Student Aid (FAFSA) as soon as possible since some student aid is available on a first-come, first-served basis.

If you can’t avoid debt, planning how to manage your debt can reduce your costs and help you avoid unnecessary stress. The key is to know where you stand before you fill out that first application, and then to stay on top of it until it is paid off. One way to get your credit scores is with an account from Credit.com, where you can get your credit scores for free, then monitor them each month at no charge.