Debts On Ice

Debt is not always a bad thing and is often necessary.  Here we provide an overview of how you can distinguish between what is good debt and what is bad debt.  This is important to know before you make that next large purchase, buy that new car, or take out another credit card.  It is almost impossible to live debt-free; most of us can't pay cash for our homes or our children's  educations. But too many of us let debt get out of hand.

Sometimes it makes sense to borrow - a lot of times it doesn't

Ideally, experts say, your total monthly long-term debt payments, including your mortgage and credit cards, should not exceed 36 percent of your gross monthly income. That's one metric mortgage bankers consider when assessing the creditworthiness of a potential borrower.

It's far too easy to spend more than you can afford, especially when you pay by credit card. The average household with at least one credit card carries nearly a £6,500 balance, according to CardWeb.com, and personal bankruptcies have hit record highs in recent years.

Of course, avoiding debt at any cost is not smart either if it means depleting your cash reserves for emergencies. The challenge is learning how to judge which debt makes sense and which does not and then wisely managing the money you do borrow.

Good debt includes anything you need but can't afford to pay for up front without wiping out cash reserves or liquidating all your investments. In cases where debt makes sense, only take loans for which you can afford the monthly payments.

Bad debt includes debt you've taken on for things you don't need and can't afford (that trip to Tahiti, for instance). The worst form of debt is credit-card debt, since it usually carries the highest interest rates.

Sometimes the decision to borrow doesn't hinge on how much cash you have but on whether there are ways to make your money work harder for you. If interest rates are low, compare what you'll spend in interest on a loan versus what your money could earn if it were invested. If you think you can get a higher return from investing your cash than what you'll pay in interest on a loan, borrowing a small amount at a low rate may make sense.

Debt is not always a bad thing. In fact, there are instances where the leveraging power of a loan actually helps put you in a better overall financial position.

1. Buying a home

The chance that you can pay for a new home in cash is slim. Carefully consider how much you can afford to put down and how much loan you can carry. The more you put down, the less you'll owe and the less you'll pay in interest over time.

Although it may seem logical to plunk down every available penny to cut your interest payments, it's not always the best move. You need to consider other issues, such as your need for cash reserves and what your investments are earning.

Also, don't pour all your cash into a home if you have other debt. Mortgages tend to have lower interest rates than other debt, and you may deduct the interest you pay on the mortgage loan. (If your mortgage has a high rate, you can always refinance later if rates fall. Use our calculator to determine how much you might save.)

A 15 to 20 percent down payment is traditional and may help buyers get the best mortgage deals. Many homebuyers do put down less - as little as 3 percent in some cases (however, not common in these tough economic times where 10% is frequently the lowest). But if you do, you'll end up paying higher monthly mortgage bills because you're borrowing more money, and you will have to pay for primary mortgage insurance (PMI), which protects the lender in the event you default.

2. Paying for university

When it comes to paying for your children's education, allowing your children to take loans makes far more sense than liquidating or borrowing against your pension fund. That's because your children have plenty of financial sources to draw on for university, but no one is going to give you a scholarship for your retirement. It's also unwise to borrow against your home to cover university fees. If you run into financial difficulties down the road, you risk losing the house.

Your best bet is to save what you can for your childrens educations without compromising your own financial health. Then let your kids borrow what you can't provide, especially if they are eligible for a government-backed loans, which are based on need.

3. Financing a car

Figuring out the best way to finance a car depends on how long you plan to keep it, since a car's value plummets as soon as you drive it off the lot. It also depends on how much cash you have on hand.

If you can pay for the car outright, it makes sense to do so if you plan to keep the car until it dies or for longer than the term of a high-interest car loan or pricey lease. It's also smart to use cash if that money is unlikely to earn more invested than what you would pay in loan interest.

Most people, however, can't afford to put down 100 percent. So the goal is to put down as much as possible without jeopardizing your other financial goals and emergency fund. Typically, you won't be able to get a car loan without putting down at least 10 percent. A loan makes most sense if you want to buy a new car and plan to keep driving it long after your loan payments have stopped.

You may be tempted to use a home equity loan when buying a car because you're likely to get a lower interest rate than you would on an auto loan. But before going this route make sure you can afford the payments. If you default, you could lose your home. And be sure you can pay it off while you still have the car since it's painful to pay for something that has been consigned to the junkyard.

Leasing a car might be your best bet if the following applies: you want a new car every three or four years; you want to avoid a down payment of 10 percent to 20 percent; you don't drive more than the 15,000 miles a year allowed in most leases; and you keep your vehicle in good condition so that you avoid end-of-lease penalties.

Whatever route you choose, shop for the best deals. Remember, it's in the car dealer's best interest to finance at the highest rate possible, so look at what you'll pay overall, not just the monthly amount. If you tell your car dealer you can spend £400 a month, you could end up with a new car for £400 a month based on an uncompetitive interest rate.