Editor’s Note: Below is an article published first at MarketWatch that was written by Elaine Scoggins, CERTIFIED FINANCIAL PLANNER(TM) and director at Merriman
Early in my career, I knew a wealthy man who took his own life. He left a suicide note saying he was pushed to the breaking point trying to pay back some sizeable business and personal debt.
From the outside, he appeared to have it all: a successful business, a beautiful new luxury home, expensive vacations and a wonderful, loving family. But, like with so many people we’re impressed by, no one knew about the dangerous levels of debt he’d taken on in order to have all those things.
I use this story knowing it is an extreme case. Debt, in the right amounts and at the right times in our lives, can be very beneficial in helping us get ahead. But if you get into a situation where you can’t pay it back, it can turn out to be one of the ugliest nightmares you’ll ever face.
You might think that if the lender says you’re fine to borrow the money, it must be OK to proceed. But there’s one gigantic problem with those income and debt ratios that are commonly used to screen us all before we borrow: They assume nothing in your life is going to change.
Taking the time to honestly answer these five questions could save you from years of misery.
Do I have to depend on positive economic trends continuing?
Here’s what went wrong with the man I referred to at the beginning of this article: The economy was booming when he took out all his debt. He assumed this would continue. When the country went into a recession two years later, his small business revenues plummeted leaving him unable to make his loan payments.
Borrow as if the economy is going to be lousy, not as if it’s going to soar. Many of us have jobs or small businesses that are highly sensitive to the health of the economy. If this is the case for you, figure out your plan B for repaying the loan if the economy doesn’t do what you hope it will. Again, hope is not a good repayment plan.
And if you decide to take out a floating rate loan, ask yourself if you could comfortably handle the larger payments if rates rise. No one ever dreamed in 1981 and 1982 that mortgage rates would hit 16%. I lived through that time and it wiped out many people who had adjustable rate loans.
Do I need two incomes to pay this loan back?
The biggest problem with the “two-income” plan is that it gives you and your partner little freedom to change your lives. What happens if, after you take the loan out, one of you loses your job, wants to go back to graduate school or to stay home with young children?
If you cannot make the loan payments without that second income, what will you do? Hoping for the best is not a good answer.
How close am I to retirement?
If you are within five to seven years of achieving financial freedom, be very wary of taking on new debt, especially sizeable long term debt like a residential or commercial mortgage. Are you really willing to trade your financial freedom and the peace of mind that comes with that for the thing you are about to buy?
I’ll call out one other dangerous kind of borrowing for all of us, but especially for those who are close to retiring: investing in a high risk venture or investment. If it doesn’t do well, not only can you lose your money, you’ll be stuck with the debt. Learn to say “no thanks” to keep your nest egg safe.
What is at the core of my need to borrow?
Who among us has ever borrowed to buy something, thinking our friends, neighbors, or colleagues would like us better if we owned it? Of course the answer to that is: all of us. The reality is that years from now when we’re still laboring to repay the debt, we won’t even know these people or remember what we borrowed the money for.
Is it any wonder that borrowing to create an illusion of success almost always leaves us feeling unfulfilled, shallow and stressed out? Bottom line: our true friends will always value us for who we are, not for what we own.
Can I keep saving for retirement while paying this loan back?
If your answer is no, I think you’ve already guessed what I’m going to say … don’t do it.
Now, if you answered my five key questions above with accurate and reasonable answers, congratulations. But before picking up the phone to make an appointment with a lender, there’s one last step I want you to take.
Ask yourself this: “Is there another way to accomplish what I really want to accomplish without borrowing money?” This will require you to stop and think before you act. By taking this extra time to think about it, you may find another option that leaves you happier in the long run.
For example, instead of rushing to borrow $40,000 for a new car, a friend of mine instead stopped and thought about it for a while. As a result, he ended up borrowing $4,000 to refurbish the car he already owned. He’s happy because his car now looks brand new. He’s also breathing a sigh of relief because his new monthly loan payment will be so much easier to make than if he’d rushed out and borrowed to buy a new expensive car.
The more you think about it, the more likely you are to come up with an alternative plan that’s even better than the one you had in mind because it gets you what you need while taking on less or no debt. If so, you could be saving yourself from the worst financial mistake of your life.