Managing Credit Properly

When Buying on Credit Makes Sense

Using credit to purchase things certainly does have its place, and there are situations where we are clearly better off enjoying the benefits of something now and paying it off over time, even though interest is involved.

The perfect example of this is when buying a home. Very few people have the means to purchase a home with their own resources. They could perhaps save up enough over time, but that’s just not realistic at all in the overwhelming majority of cases.

Let’s look at an example of why this isn’t really possible. If we have $1500 a month that we can spend on housing costs, and we set that aside, in 20 years we will have $360,000. If we had that much today, we could probably buy our own house depending on the area and what we’re after, but that’s what they cost now, and in 20 years, the price will have risen perhaps to twice as much, or more.

If it then costs $720,000, we’ve saved up our $360,000, but this is well short of what we need. Even more notably, we’re going to have to find a place to live for these 20 years, and even if we are willing to cut back and rent a more modest place than we’re shooting for, we’ll say one for $800 a month, we are not only sacrificing our comfort and lifestyle, but this will mean that we’ll only save up $168,000 over these 20 years, nowhere near close to what we’ll need if we ever want to own our own home.

We’ll have to continue to rent forever really, as 40 years won’t be enough here as well, and our lives will be spent paying a premium to landlords and also not gaining the increases in value over time of the home we would have bought.

If we buy our home on credit though, with a mortgage, then a good portion of the money we spend on payments will be used to pay down the loan, leaving us with a net gain over time. As the property increases in value, this also builds wealth for us, and in our scenario where the home costs $360,000 and rises to $720,000, we will gain the $360,000 plus the amount of the principal paid off, and we may pay off the whole thing and gain the entire $720,000.

We Still Need to Exercise Restraint

That’s a big difference and as an added benefit, we get to live in the home all these years, and will typically live in a better home if we buy one than a home we would rent. However, a lot of people tend to shoot bigger here than they should, where their housing costs end up representing too high of a proportion of their income than it really should, due to their stretching things out to the maximum they can afford.

Mortgage lenders give us quite a bit of latitude here, allowing us to take on payments that involve us spending half of our net income on housing costs, including our mortgage payments, property tax, and condo fees if one lives in a condo. There are also the upkeep costs that need to be factored in, as well as other costs such as extra property insurance, life insurance to insure the mortgage, higher utility costs, and so on.

Therefore, as sweet a deal as owning your own home is, we need to be careful here not to take on more than we can handle, where our housing costs may limit our access to other things that we need, including the need to save enough.

There are a lot of people who are in this situation, not from borrowing in itself but by borrowing too much. While it is important to tend to our needs and desires, this always needs to be done in the context of our capacity, as well as accounting for the opportunity cost of spending money on something versus something else what may be a wiser purchase, and especially in losing the ability to save this money for the future.

We do need to spend though, and need to find the right balance between spending and saving, which does require a fair bit of thought and consideration. This is an issue with or without borrowing, as we can spend all of our money without credit, but borrowing adds to the potential of our overdoing things, as well as adding additional costs due to interest.

There are two main considerations when considering borrowing, which are whether we should be buying the item in the first place and whether we should buy it now rather than wait, if it’s possible or realistic to wait.

With our home purchase, waiting is very likely not realistic, but with some things it is. Buying a home delivers enough benefits that the interest we pay becomes well worth it, but with other things, it may not be.

If we are considering buying a new car, we may be tempted by what seem like very low interest rates offered as an incentive, even though the extra financing costs that we may think that we are saving are built into its price, as is always the case. Car companies buy down the rate for you but you can bet that they don’t do this because they are feeling generous, as these costs require them to charge a higher price for the car than they would otherwise.

We should be using the market rate when we look to calculate the costs of borrowing, and this can add up to a fair bit more over the term of the loan. This can be worth it to us though, but we need to consider if it is and not just buy without much thought as people tend to often do.

When we save up for things, we earn interest instead of paying interest, and the two rates need to be added together to determine the true cost of borrowing versus saving and waiting. What we get in return for this is access to what we’re looking to buy now versus later, which in itself can be of value.

How much value we get here will depend though upon the circumstances, and this must be accounted for in our deliberations. With some things, we may not have much choice to buy it now, but with others, they may be highly discretionary and the costs of getting it now may not be worth it.

We need not worry all that much about these things too much though, as this really should not require any sort of detailed calculation, and just using our feelings about the matter may suffice. These feelings need to be based upon how we feel after we think about all of the aspects of the decision, not just the desire to have it now without thinking very much about it beyond that.

Credit and Financial Capacity

Should we decide to borrow, we may be fine with the additional costs of doing so, but we need to pay close attention to allowing borrowing to undermine our financial capacity.

Lenders will sometimes, but not always, show a reasonable amount of restraint, although with credit cards there is far less of this used, and credit card issuers are known to extend our borrowing capacity well beyond any conception of reasonableness. Many people would get themselves into extreme difficulty or even well exceed their capacity to repay if they took advantage of all of the available credit offered to them.

Lenders are also only really concerned about the risk to them of borrowers defaulting, and they don’t really care whether or not we are very wise with our money at all, and are fine with our living out our lives hand to mouth with nothing to show for a lifetime of work in the end, provided that we can sustain this.

The debt ratios that they use are therefore within their risk tolerances generally, but may be well out of line for us. If we are living on the edge with our ratios of debt to income, then we’re pushed to the limit at the best of times, and may be in for a great deal of trouble should unforeseen circumstances arise, such as large unplanned expenses or the loss of one’s job for a time.

These are things that we need to prepare for adequately, and this involves setting aside quite a bit more than higher debt ratios would ever allow. If we are to use credit responsibly, we are therefore going to require a higher standard than lenders provide, ensuring that we only borrow when it is justifiable from a value perspective and also when it doesn’t unduly interfere with our other financial goals.

If we don’t use credit, our financial capacity represents a natural restraint upon our spending, even though we can still well overdo it and end up in some bad situations. Credit increases the risk of overspending substantially, as how much money we make isn’t the limit anymore, and we can spend substantially more than we make.

As the debts from borrowing pile up, the interest costs do as well, and we can find ourselves at the point where servicing this debt becomes totally unmanageable. People with revolving lines such as lines of credit and credit cards may end up maxed out and just paying the interest to avoid defaulting, but these interest costs can be very substantial, with no real benefit involved other than staving off these defaults, and not even paying down the principal and getting a little ahead over time at least.

Generally, people have a combination of installment and revolving debt, and if they are fortunate enough to have built up some home equity, they may use that to help pay off some of this debt, transferring it to their mortgage. This results in a loss of wealth, and often times people will continue to repeat the same mistakes and need to do this several times, and end up with a large mortgage even in their retirement years, from using credit as a tool to overspend.

We all need to be aware of our real capacity to spend, at least if we’re looking to do so sensibly. It is important indeed to do our best to avoid spending too much, whether it is our own money we are spending or if we are borrowing it.

Credit, used responsibly, can enhance our lives by allowing us to receive what we need when we need it rather than later. We have to make sure that we remain mindful of both the additional costs of borrowing and especially looking to avoid using credit to buy things we really should not be buying.

If we manage to get this right though then we can continue to pursue our personal financial goals and strive to achieve the level of success we desire and still do some borrowing when it makes sense to.