For many, debt is a feared, four-letter word. The recent debates in Congress over the national debt may have prompted citizens to evaluate their own financial circumstances. In fact, while the scale and nature of expenses may be vastly different, the underlying principles regarding spending can be applied both to large entities such as governments, as well as individuals.
First, it may be helpful to identify two primary expense categories: capital expenses and operational expenses, which may include investing in education. Capital expenses include those from which you could reasonably expect a future return — financially or otherwise. For an individual, these may include costs associated with buying a house and the utility of driving a car. Related operational expenses typically do not generate a profit and may consist of the utilities for your home, gas for your car, and food for your family.
When it comes to paying for the many expenses that an entity or individual may encounter, there are generally four ways to finance them. Most people use a combination of all four methods at varying levels.
The first option is to pay as you go. If you were to use this method to build a house, available money may be spent to pour the foundation and frame the house, but once the existing funds are depleted, further construction necessary to complete the home must be postponed until more money becomes available.
While paying as you go is one way to avoid going into debt and paying interest, there are clear disadvantages such as the sheer time involved completing a project for use. This factor can also result in an increase in total cost over time if there is inflation in construction costs. As a result, this option may not always be the most practical solution for large capital expenses, but may be a good way to satisfy smaller capital and operational costs.
The second financing method is to save up and set aside. If not under time constraints, this can be a realistic choice when considering large expenses. Just as it sounds, this approach involves saving money and investing it. For an individual, this may involve designating a portion of your earnings to be deposited into a savings account, invested in bonds, or other fixed-income vehicles.
While this option may not produce the most immediate results and may be subject to inflation and other risks associated with fixed-income investing, it does not require borrowing and there is the added benefit of earning interest rather than paying it.
The third possibility is obtaining grants, which may come in the form of government grants for housing or education, or as an inheritance or gift. One obvious advantage of grants is that, in many cases, the amount received does not have to be repaid.
However, you may relinquish some control if the benefactor has specific parameters or intentions as to the usage or distribution of the funds. For instance, relying on a significant inheritance to make a large immediate purchase may not be realistic if allotments are made in small increments over time.
Finally, the fourth option for funding expenses is debt financing. The most apparent benefit of debt financing is your ability to use the money immediately. This can be ideal in terms of capital expenses, which are often associated with significant costs — either up front as with a home or in installments as with education. Yet this convenience comes at a literal price — interest.
All debt — from mortgage and auto loans to credit card balances — must be repaid plus interest, which can exponentially add to total out-of-pocket costs over time. As a result, it is important to determine how much debt you can reasonably afford. Credit cards and loans can allow for great utility, but can be detrimental if you are unable to pay back what you have borrowed.
People often ask whether debt is good or bad, or what constitutes good debt versus bad debt. It often carries negative connotations and is avoided by many, while some believe debt to be a necessary evil. There may be no definitive right or wrong answer, but it may be helpful to consider debt as a resource, like water. When used correctly and with vigilance, water can be successfully used for hydration, sanitation, recreation, and to fulfill other necessities.
However, when used irresponsibly and without due attention, water may be destructive and even fatal. In the same way, you can drown in your debt if it is used carelessly. Conditions beyond your control such as rain and natural disasters can affect the impact of water. Comparably, external events and decisions may also influence your debt and overall financial standing, so it is important to be prepared and remain conservative in your forecasts.
Some consider the resulting debt from buying a house or paying for education to be “good debt,” as greater returns on the initial investments may be realized over time. Still, everyone’s comfort level regarding debt is different and what works for one individual may not be the answer for another.
To avoid sinking in debt, ask yourself which costs are essential and evaluate the best way to cover them. With an understanding of your own capacity to manage debt responsibly, debt can be a useful tool.
Alan Westenskow is a Vice President at Zions Bank Public Finance where he assists local governments issue municipal bonds to finance infrastructure projects. He can be contacted at firstname.lastname@example.org