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. Here are a few:
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 spend every available dime 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 first $1 million of a mortgage loan. (If your mortgage has a high rate, you can always refinance later if rates fall. Use our mortgage calculator to determine how much you might save.)
A 20% down payment is traditional and may help buyers get the best mortgage deals. Many homebuyers do put down less -- as little as 3% in some cases. 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.
For more on financing a home, read Money Essentials: Buying a home.
Paying for college
When it comes to paying for your children's education, allowing your kids to take loans makes far more sense than liquidating or borrowing against your retirement fund. That's because your kids have plenty of financial sources to draw on for college, but no one is going to give you a scholarship for your retirement. What's more, a big 401(k) balance won't count against you if you apply for financial aid since retirement savings are not counted as available assets.
It's also unwise to borrow against your home to cover tuition. 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 kids' 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 Perkins or Stafford loans, which are based on need. Such loans have guaranteed low rates; no interest payments are due until after graduation; and interest paid is tax-deductible under certain circumstances.
For more on educational financing, read Money Essentials: Saving for College.
Financing a car
It makes sense to pay for a car outright if you plan to keep it 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%. 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%. 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, and the interest is tax-deductible. But make sure you can afford the payments. If you default, you could lose your home.
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% to 20%; 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.
For more on auto financing, read Money Essentials: Buying a car.
Making home improvements
Taking a home equity loan or home equity line of credit makes sense if you're making home improvements that increase the value of your house, such as adding a family room or renovating your kitchen. The interest you pay in many cases is deductible, and you increase your equity.
If, however, a home project doesn't boost your house value, consider paying cash or taking out a short-term, low-interest loan that will be paid off in five years or less.
Generally speaking, it's best to pay up front for furniture and appliances since they don't add value to your home and are depreciating assets.
Paying off credit card debt
If you're saddled with a lot of high-interest credit card debt, you might be tempted to pay it off quickly by borrowing from your 401(k) or taking out a home equity loan.
There are two primary advantages to home equity loans: They typically charge interest rates that are less than half what most credit cards charge. Plus, the interest you pay may be deductible. (Note, however, that when you use a home equity loan for nonhousing expenses, you may only deduct the interest paid on the first $100,000 of the loan, according to the National Association of Tax Practitioners.)
But there is one potential and very significant drawback when you borrow against your house to pay off credit cards: If you default on your home equity loan payments, you may lose your home.
Borrowing from your 401(k) is even less advisable. That's because you lose out on two of the biggest advantages to workplace retirement plans: tax-deferred compounding of your money and tax-deductible contributions. Sure, you pay yourself back with interest, but that interest is paid with after-tax dollars, and it will be harder for you to make new contributions while you're repaying your old loan.
Also, if you quit or lose your job, you'll probably have to repay the entire borrowed amount within three months. If you aren't able to do that, you'll owe income taxes on the money, plus a 10% penalty if you're under 59-1/2.