For many people, debt is a scary concept that they think should be avoided whenever possible.
There are thousands of apps, podcasts, and books dedicated to teaching people how to get out of debt. And while debt can be seen as a negative, it can also have a positive impact on your finances. Taking on debt in a responsible manner can be one of the strongest and most underappreciated financial tools available to you.
This article discusses a few ways you can use debt to your advantage – as well as what to avoid – so you can make the best decisions when it comes to your finances.
1. Increasing Your Credit Score
Homebuyers know they need a good credit score to qualify for the best financing terms, but borrowing responsibly and building credit can be difficult.
As a mortgage lender, we often have clients who come to us looking for their first home, very proud that they’ve never had an ounce of debt in their entire life. No credit cards, students loans – not even a car loan. Unfortunately, they are thrown for a loop when they find out that they can’t qualify for home financing. Why? Because they either have no credit score or too low of a credit score.
On the flip side, we also work with a lot hopeful borrowers who are so buried by credit card and installment debt (like car loans or personal loans), that they are unable to save for down payments or have too high of a debt-to-income ratio to qualify for the mortgage they want.
You need to credit to get credit. For someone who does not have good credit, home financing can only be obtained with a significant down payment. Even with a large down payment, interest rates will often be higher than they would be for a borrower with a good credit history.
The best financing options always require good credit scores.Debt that you are able to pay responsibly based on the loan agreement can be seen as “good debt”, as a favorable payment history (and showing you can responsibly handle a mix of different types of debt) will have a direct impact on your credit scores.
If used wisely, this type of debt can set you up for financial success. Credit card accounts can be the ticket to sky-high credit scores. The key is to keep the balances paid off or under 30% of the limits.
And when it comes to buying a home, good credit scores are very important – they can impact mortgage rates by as much 1%.
Leverage is using borrowed money to invest. Businesses use leverage to fund growth, and financial professionals use leverage to boost their investing strategies.
For individuals, the power of leverage allows you to finance purchases with fewer out of pocket dollars and save your cash for other purchases or investments.
When it comes to your personal finances, you may be surprised at how often you use leverage. Whenever you borrow money to acquire an asset or potentially grow your money, you’re using leverage:
- Buying a home: When you purchase a house with a mortgage, you are using leverage to buy property. Over time you will build equity in the home as you pay off your mortgage. And as long as home values are appreciating, you will continue to see a handsome return on your investment.
- Taking out student loans: When you borrow money to pay for school, you’re using debt to invest in your education and your future. Over time, your degree boosts your earning potential. A higher salary then lets you recover your initial investment that you used debt to pay for.
- Buying a car: Car loans are a form of leverage that should be used carefully. Cars are depreciating assets, meaning they lose value over time. But you generally buy a car to provide transportation, and owning a car may be necessary for you to earn an income.
In all of these examples, the debt is being used to provide a greater financial position than would have been possible without borrowing money.
3. Cash-on-Cash Returns
In real estate investing, a cash-on-cash return is the rate of return that calculates the cash income earned on the cash invested in a property.
For example, let’s say last year you bought a $500,000 house with a $75,000 down payment. After one year, you find out your home value has appreciated 10%.
Appreciation is based on the entire value of the house, not just the amount you have invested. 10% appreciation on a $500,000 house is $50,000, so you now have $125,000 in equity (or cash) in your home after only a $75,000 investment – that’s a 67% cash return on your cash investment.
4. Harness the Power of Inflation
Just like debt, inflation is another word with negative undertones when it comes to impact on your personal finances.
What many do not realize is that inflation and fixed-rate debt work together for your benefit!
When someone buys a property, they often only consider the initial cost. What if you were able to fast forward 20 years? That initially shocking purchase price will likely look much more manageable.
Here is the reason why: the cost of debt will remain constant while your income will likely go up and the loan balance will go down as you continue to make payments.
Inflation increases prices across the board, making dollars less valuable. Over time, this helps homeowners destroy debt with the properties they own. They will be paying off the mortgage with future less valuable dollars. This is known as inflation-induced debt destruction.
Many borrowers have become very wealthy because they were able to pay off debts – with much less valuable dollars – during times of inflation.
The Bottom Line
In addition to simply being able to qualify for home financing, borrowing money can be beneficial for homebuyers in several ways. Properly managed debt will help you build your credit so you can borrow money to invest for higher returns.
If you’re considering buying a home and you’re curious about what types of debt will have the biggest impact on your credit score, fill out the form to request a consultation with one of our mortgage advisors. They will be able to take a look at your overall debt picture and help you put a plan in place to increase your credit score so you can qualify for the best loan terms possible.