Finance

How to Use Debt to Create Wealth | Family finances

According to data from the Federal Reserve Bank of New York, total US household debt was $16.51 trillion in the third quarter of 2022, an increase of 2.2% compared to the second quarter of this year. But while debt often gets a bad name in personal finance circles, it’s not always a bad thing for personal finance.

“Debt can be an extremely powerful tool when used properly,” says Michael Tanney, senior managing director of New York’s Magnus Financial Group.

But like most powerful tools, if you use it wrong, it can hurt you. It is necessary to take on debt for the right reasons and under the right leadership, he says.

When you use debt responsibly, it can help you gain financial security and build your net worth. Keep reading to find out how.

How does good debt differ from bad debt?

Financial experts say there is good debt and bad debt. Good debt includes loans—like mortgages, student loans, and small business loans—that allow you to purchase property with the potential to gain value over time. (In the case of student loans, you’re getting access to a career that’s likely to give you higher earning potential.)

Bad debt usually involves high-interest financial products – such as credit cards – that you use to buy items that depreciate in value or that you consume quickly. This type of debt can be a hindrance to your finances and prevent you from achieving other financial goals.

Grant Sabatier, creator of the personal finance blog Millennial Money and author of “Financial Freedom,” says that when we hear about bad debt, it’s usually about high-interest credit cards.

When you only make the minimum payments on your credit card bills, the amount you owe continues to grow and rapidly increase and can put you deep in debt before you know it.. Bad debt also includes copays and other predatory loans, Sabatier says.

How to Build Wealth When You’re in Debt

When you use debt assets, it shouldn’t stop you from increasing your net worth over time. Follow these steps to take control of your debt and move forward financially.

Pay off high-interest debt first

If you have funds on your credit cards, stop using them for a while. Direct your funds toward paying those balances each month, starting with the card with the highest interest rate.

Credit cards can serve as a great tool for improving your credit score, maximizing your cash flow, and collecting rewards points. But if you carry a balance each month, the interest cost will usually outweigh any of those benefits. Switch to using a debit card or cash until you pay off your cards.

Set aside savings

Setting aside three to six months of savings will help prevent you from going back into debt if an emergency arises—like an unexpected home repair or job loss. Aim to put some money into your emergency fund each month and at least enough into your retirement account to take advantage of your employer’s benefit.

“You don’t want to take an all-or-nothing approach to paying off debt that alienates your other financial goals,” says John McCafferty, director of financial planning at Edelman Financial Engines.

Only take on additional debt if you have a plan to pay it back

Whether it’s a small business loan, student loan or mortgage, think carefully about the amount of money you want to borrow and whether you’ll have the resources to pay it back. For example, if you’re going back to school and taking out a loan, make sure your projected salary after graduation will allow you to comfortably pay.

Don’t eliminate your “good debt” too quickly.

If you were one of the millions of Americans who took advantage of the record low interest rates of the past decade and secured a mortgage at the lowest rate, don’t rush to pay it off.

Instead, put that money you would use to pay off your mortgage into a high-yield savings account. That way you can earn up to 4% interest, which would be a higher return than you would get from paying off a 3% mortgage. Or, invest money in the stock market. Although it’s unpredictable right now, if you don’t need the funds in the near future, it might be a good place to put some money.

“The stock market has historically produced an average of 8% to 10% annually, depending on the time period you look at,” says Paul Dietrich, chief investment strategist at B. Riley Wealth. “If your debt is less than that, you can focus on investing instead.”

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