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How to borrow money and avoid bad debt

Key Points
  • Aggregate household consumer debt approached $14 trillion in 2019, and continues rising.
  • Knowing your debt-to-income ratio and credit utilization ratio will help you stay out of trouble.
  • Avoiding variable interest loans, comparison shopping for the best rates, and working with a single lender, can all help you borrow wisely. 
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Tips to rememeber when borrowing money

If you don't have consumer debt, congrats! You're in the prudent and fortunate minority. Aggregate household consumer debt approached $14 trillion in 2019, and continues rising, despite higher wages and lower unemployment. In part, that's driven by a robust housing market, drawing in new mortgage borrowers. But student loan, credit card, and personal loan balances are also growing, suggesting many households may soon be feeling overstretched, if they're not already.

There are many circumstances in which it's appropriate to borrow money, so it's worth keeping a few rules of thumb in mind when taking on debt. There are distinctions to be made between "good debt" and "bad debt," but the greatest impact of all may be whether you manage whatever you borrow effectively.

Here are some very simple, and essential, dos and dont's of borrowing to live by.

Don't do this

Don't borrow when you're already deep in debt. You can't solve debt with more debt. Cut your losses and trim your budget before debt snowballs out of control. How do you know if your debt is excessive? A simple calculation called the debt-to-income ratio compares your monthly gross income to your monthly debt payments. Anything over 43% is worrisome, and a sign you should avoid new debt at all costs.

Don't choose variable rate loans for mortgages, car notes, student loans or anything else. The risks associated with variable rate loans outweigh whatever small incentives or upfront benefits you might find attractive. Remember the housing and subprime credit crisis of 2007-2008? It was in part precipitated by borrowers attracted to ARMs (Adjustable Rate Mortgages). These mortgages featured low interest rates at the beginning, which later increased significantly and triggered defaults. It's always best to know how much interest you'll be paying over the life of the loan, and have a clear understanding of your monthly payment obligations. This is easiest to achieve with a fixed rate loan.

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Don't borrow money without reading the fine print carefully. Interest rates or repayment terms may be less favorable than you assume. Your options for modifying the debt could be minimal. Liens could even be placed on your property. How would you know, however, if you didn't take the time to read the fine print, and more importantly, fully understand it? Take your time and be certain you understand any agreement. Ask questions of your borrower. If you still don't understand a consumer loan or borrowing matter, contact the CFPB, or ask a professional, such as an attorney or accountant. (I once had a lien nearly placed on property, and wish I had taken my own advice sooner to read the fine print.)

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Don't borrow more than you can afford to repay. This tip sounds obvious, but it still gets millions of Americans into trouble each year. Be absolutely certain that you'll be able to pay off the debt in full. That means being certain you'll have the income you need on an ongoing basis to repay, and that you can cut back your budget to afford it. That's why taking on a mortgage, or any other long-repayment term loan, is such a huge undertaking, and why borrowing less than you can afford is the most prudent action.

Do this

There are equally simple and concrete steps you can take to make borrowing more efficient, and reduce any repayment risks you might encounter over the life of the loan. These steps also have the added bonus of helping to improve your credit over time.

Do negotiate the lowest possible interest rate when taking on debt. Whatever type of debt you're assuming, seeking out the lowest interest rate possible ensures that you'll pay less over the life of the loan, and thus bear lower risk of delinquency or default should you encounter financial difficulty. Always comparison shop for interest rates, and ask for any interest rate reductions available, such as for putting your repayment on autopay. When you've successfully paid on time for several months, ask for interest rate reductions for a history of on-time payments.

Do make more than the minimum payments on loans, as this will result in you paying significantly less interest over the life of the loan. A simple trick for this involves making bi-weekly, instead of monthly payments on your loan. As an example, if your monthly student loan bill is $400, pay $200 every other week, instead. If you used the traditional monthly payment method, you'd pay $400 x 12 months = $4,800 per year. Under the bi-weekly method, you'd pay $200 x 26 bi-weekly periods yearly = $5,200 per year. You're making an extra full month of payments while barely even noticing it. On a ten-year repayment schedule, this could reduce your repayment timeline by an entire year. It'll also result in far less interest paid.

Do concentrate your borrowing to a single lender, or as few as possible. Borrowing from a single lender whenever possible, such as having your mortgage, credit cards, and personal line of credit with your bank, helps to obtain lower interest rates, minimizes fees in some cases, and establishes good will for moments of financial difficulty. Build a good reputation with a primary lender, and over time, you'll reap the benefits.

Do keep your overall credit utilization ratio below 30%. It's the proportion of the credit you're using to your overall available credit. A ratio over 30% lowers your credit score. It also means you're simply living on too much credit and likely facing financial difficulty. Your credit utilization ratio comprises a significant portion of your credit score calculation, and keeping it below 30% yields you the greatest points.

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