What is ‘Necessary’ Debt and How Do You Plan for It?

Just about everyone incurs debt of some kind, at some point in their lives, regardless of their income and net worth, be it a mortgage, a business loan or unexpected medical bills. The key is how you plan for it.

As financial advisors in San Antonio, Texas, we’d love it if everyone could live life completely debt-free, but we realize that it’s nearly impossible to establish and maintain a good credit score if you just pay cash for everything. And in some ways, certain types of debt can be a good thing. Very few people pay cash for their first home, for example, and real estate can be a great investment, with tax benefits and equity opportunities.

The problem is, many people mistake what necessary debt really is. Note: It’s not Christmas shopping!

Generally speaking, what makes a debt necessary is if it can potentially increase your net worth (like student loans or a mortgage), if it can improve or expand your business (like a business expense or loan) or if it’s required and essential (like unexpected medical bills).

In these situations, how you handle the debt can make a big difference. For example, if a debt doesn’t cost much, has a relatively low interest rate and future value, and will eventually make you better off for having taken it on, having the loan can actually be a good thing.

Bad debt, on the other hand, is pretty easy to identify, like high-interest credit card debt, personal loans, payday loans, even some auto loans. Bad debt is expensive borrowing that’s often more than what someone can afford to pay back, or borrowing to buy something that is likely to decrease in value.

Some examples of necessary debt you may someday incur include:

  • A Mortgage: A mortgage is probably the single biggest debt you’ll ever take on, but it can also be one of the most valuable, because when it’s paid off, you can own a significant asset that more than likely has appreciated in worth considerably since you bought it.
  • Business Expenses: If you take a loan to build up your business, or to pay business expenses, you can consider those an investment into the future success of the company. The long-term value of such an expense should far outweigh the short-term cost, if it allows you to grow your business.
  • Medical Bills: Although this type of debt won’t improve your financial situation, what makes it necessary is that by their nature, medical bills are unexpected and pretty much unavoidable. These can be the result of an illness, accident or injury, any of which can happen to anyone, anywhere, at any time. High-cost hospital bills are not beyond the realm of possibility, especially when it involves major surgeries and long hospital stays. Don’t forget that your ability to work and earn (to pay these medical bills) may also be compromised, at least temporarily.

A natural disaster can be another reason you may have to take on debt, as the effects of an earthquake, flood or fire can be devastating. Insurance doesn’t always cover everything! For more on natural disaster planning, read our recent blog post: Natural Disaster Planning in San Antonio.

Have questions about your finances? Schedule a no-strings-attached conversation with the team at PAX Financial Group.

How to Plan for Necessary Debt

It’s hard to plan for the unexpected, especially when it comes to your finances. But it can be done. Here are some PAX Financial Group tips:

  • Have a spending plan. Even the wealthiest of people can’t always afford to spend haphazardly. Knowing what is coming in and what is going out gives you a chance to hold yourself accountable for expenses, and make the most of your money by saving or investing it rather than spending it.
  • Avoid unnecessary debt. If you do use a credit card, pay off the balance in full each month, to avoid accumulating interest and a balance that creeps up. Keep the number of credit cards you have and use to a minimum – the more cards you have, the tougher it can be to manage the accounts. Taking on debt for necessary reasons can be easier when you don’t already have debt for unnecessary reasons. Maintaining a healthy emergency fund – at least six months of regular living expenses – with quick access to cash, can also help.
  • Don’t borrow more than you need. Just because you’re able to borrow doesn’t mean you should, and taking more than you need could mean paying interest for no reason.
  • Consider the value. Think about whether an expense will be an investment in your future, increase your income, grow your wealth or help you medically. If you can’t answer “yes” to at least one of those questions, it may not be a worthwhile purchase.
  • Talk to your financial advisor. Often times when people meet with their financial advisor, they want to discuss big-picture goals, like retirement planning, asset allocation and wealth building. But preparing for and dealing with necessary debt is actually part of that process and the kind of scenario your financial advisor can help you plan for.

What Not To Do

Just as important as what you can do when it comes to debt is what you shouldn’t do. For example:

  • Don’t pay off debt by cashing out a retirement plan early. Tapping into your IRA or 401(k) plan early might alleviate a particular debt, but this can cost you far more over the long term in penalties, taxes and loss of growth potential.
  • Don’t put off retirement planning to reach short-term goals. With the average life expectancy continuing to increase in America, retirement can last 20, 30, even 40 years. Saving enough so you don’t outlive your money in retirement is a big task. Don’t forget that and get distracted by the here and now. This is not to say that you shouldn’t have short-term goals. On the contrary, financing your daughter’s wedding, paying off your mortgage and building an addition on your home can all be great financial goals to achieve, just not at the expense of saving for your retirement.
  • Don’t borrow just to invest. As financial advisors in San Antonio, Texas, we see this a lot. Borrowing to invest is what’s referred to in the investment world as buying on margin: Taking out a loan, hedging a bet on the stock market and hoping to rake in the returns. If it works, you keep the gains and pay back the loan. However, if your gamble doesn’t pay off, you will have to pay the money back (plus interest), and it’s likely money you didn’t even have in the first place.
  • Don’t make rash decisions. One of the most effective ways to avoid unnecessary debt is to practice mindful spending, evaluating each investment and purchase carefully and thoughtfully. Consider talking through any major expenditures with your financial advisor to see where they fall on the necessary, or unnecessary, debt spectrum.

If you have questions about debt or any change to your financial picture, schedule a no-obligation conversation with the team at PAX Financial Group and learn how our financial advisors in San Antonio, Texas can help.

This material is provided by PAX Financial Group, LLC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The information herein has been derived from sources believed to be accurate. Please note: Investing involves risk, and past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur management fees, costs and expenses, and cannot be invested into directly. All economic and performance data is historical and not indicative of future results.

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