In a perfect world, we could all get through life with the things we need while living a reasonable lifestyle without ever having to assume a single dollar in debt.
Unfortunately, for most Americans, the reality is that the things that we need, at some point, will require using debt to finance. These include the ability to find a decent place to live, getting reliable transportation, and getting through periods of financial stress.
Luckily, there are a few very simple rules that can help guide people in making responsible borrowing decisions.
Done right, borrowing can be a large net benefit to all involved. It is important, however, to always adhere to solid personal financial strategies, especially when it comes to the use of debt.
Failure to borrow responsibly can have catastrophic results to a person’s finances, job, and even personal relationships.
The two main types of borrowing
It is important to understand the two main types of borrowing. These are secured debt and unsecured debt. The chief difference between these two forms of borrowing is that secured debt requires the use of collateral, that is, an asset that is guaranteed to be liquidated in order to cover most of the underlying debt principle should the debtor fail to meet their obligations under the loan contract.
Unsecured debt often works through the use of the borrower’s credit rating and history, though in some instances the approval hinges on a person’s income rather than their credit standing. Most personal loans you can apply for online are an example of unsecured borrowing where income matters more than credit history.
Ultimately, the loan is not backed by any kind of hard asset in the event it’s not paid back. As a result, even with good credit, interest on unsecured loans will usually be higher than those backed by collateral.
On the other hand, one of the most common forms of secured debt is a home mortgage. Mortgages are almost always secured by the underlying value of the home, meaning that, should the borrower renege on their monthly payment obligations, the banker has the option to take possession of the home and sell it at auction in order to recover the full outstanding amount of the loan principal. Some other forms of secured credit include home equity lines of credit and car title loans.
What is responsible borrowing?
There is some debate about what levels of debt should be considered responsible. Most personal finance experts follow the so-called 28/36 rule. This simply means that you should end up paying no more than 28 percent of your income towards housing-related costs, including mortgage payments, and your total debt service costs should not exceed 36 percent.
You may notice that this leaves relatively little wiggle room for credit card or other non-mortgage debt for most people. For example, if someone is making $50,000 per year and they have a total of $1,000 per month in housing-related expenses, that would mean that their total debt payments from all other sources should not exceed much more than about $400.
If that person were paying $1,500 per month on housing expenses, they would already be at the absolute upper limit for total debt service.