If you need to go into debt, keep these three rules in mind

Julian Kheel, CNN Underscored
Thu May 21, 2020

At CNN Underscored, we know people are hurting financially from the coronavirus pandemic, and we want to help. So we've put together this series on how to deal with your money problems in the midst of the worst economy in at least a decade. And since this is an unprecedented crisis, we're not just offering the same old rote financial advice that you may have heard many times before. We're sometimes offering unprecedented advice, because when the present looks grim, it's hard to think about building for the future and more important to focus on fixing things now.

Over the last few weeks, we've looked at two of the three ways you can bring your budget into balance: increasing your income and lowering your expenses.

If you've recently lost your job, one way to increase your income is to get on unemployment, and last week we went over 10 steps to follow when filing for unemployment benefits. Lowering your expenses can be more challenging, but you can focus on three major categories of household expenses to reduce your costs with a minimum of pain.

But even with unemployment benefits and cutting your expenses, you still might not have enough money to make ends meet. In that case, you may find yourself in debt, as a result of using a credit card, taking out a personal loan or even borrowing money from family and friends.

Is this a terrible thing? Not necessarily, as long as you're doing it as a last resort after you've cut back your expenses as far as they can go. But there's a right way and a wrong way to handle debt, so let's dig in to make sure you're being smart about it.

'Debt' is not a dirty word

In some quarters, you'll hear that going into debt is something you should never do because it's dangerous. Some people believe once you've started accumulating debt, you'll find yourself unable to ever get out of it and your financial life will be ruined forever.

That's a little like saying you should never use a chainsaw because you could cut off your arm. If you've never been trained on how to use a chainsaw, or if you're careless with chainsaws, it's true, you shouldn't use one. But a chainsaw is a tool like any other, and if you know how to properly utilize that tool and when it's the right one to use, you can prune your trees and still have all of your arms and legs attached when you're done.

Think of debt the same way. It's another tool in your financial toolbox that can help you, if you're smart and disciplined enough to know how to use it properly.

Debt is one of the many tools in your financial toolbox.

"Debt can be used responsibly so it helps cover emergency costs while offering an opportunity to strengthen your credit history with a record of timely payments and reasonable debt management," said Bruce McClary, vice president of communications for the National Foundation for Credit Counseling. "Making payments on time and keeping balances low in relation to credit limits is a good way to help protect your credit rating and keep debt manageable within your budget."

So how do you use debt wisely? There are three important rules to remember.

Rule No. 1: Don't use debt to increase your expenses

Some people go into debt to buy nonessential items that they wouldn't be able to afford otherwise, like jewelry or a luxury car. That's a terrible idea. You should never add to your monthly expenses by using debt to buy something that you don't need.

There's one exception to this rule. It's potentially acceptable to increase your expenses with debt if you're getting a permanent asset in return. For instance, if you use a mortgage to buy a house, you're increasing your monthly expenses with a mortgage payment. But each month you make that payment, you own a bigger share of a permanent asset (your house) and the bank owns less of it.

Note that I said it's "potentially" acceptable to do this. You don't want to buy a house that's so expensive that you can't make the mortgage payment each month.

"At any point where debt becomes unmanageable and it is likely that a payment will not be made on time, that is when debt can become an increasingly difficult problem with lasting consequences," said McClary.

So even if you're getting something permanent in return, you still need to be able to pay off your debt in a timely manner. We'll get to that in a moment.

But in the middle of a pandemic, most people aren't buying houses. (Well, some are, but that's a story for another week.) Many folks are in triage mode, just trying to maintain a basic cash flow until employment picks back up. The plan is that you'll get a new job — or customers will return, if you're a small-business owner — hopefully in a matter of months or even weeks, and you need to temporarily cover the basics between now and then.

Once you've cut your expenses as low as they can go, it's reasonable to accumulate some debt to cover any remaining minimum costs, so long as you're truly only doing it for a short time to have the basics you absolutely need.

"A credit card can be a lifeline for folks who are struggling in the wake of the pandemic," said Matt Schulz, chief credit analyst at Lending Tree, an online loan marketplace. "It is definitely not an ideal situation, but the truth is that if you don't have much of a rainy day fund, your credit card might be the best option you have."

Rule No. 2: Keep the cost of your debt down

How much is your debt actually going to cost you?

You might assume that the "cost" of your debt is whatever your monthly payment is. For instance, if the minimum monthly payment on your credit card is $125, then $125 is what your debt costs each month, right?

Nope. Monthly payment amounts are very misleading. Banks can lower your monthly payment just by extending out the amount of time you have to pay off your debt. That might be helpful right now when you're short on cash, but it'll make the overall cost higher in the long run.

Instead of looking at the monthly payment, you need to find your debt's two most important numbers: the interest rate and the fees. Both will cost you money, so you want to keep them as low as you can.

Let's say you're receiving unemployment benefits, you've already cut your expenses, and you still need an additional $350 a month for the next six months to cover your basic costs. So you decide you're going to use a credit card to pay for that extra $350 each month and end up with $2,100 in debt (because $350 multiplied by 6 is $2,100).

Your bank asks for a minimum monthly payment of just $52 on your $2,100 balance, so you figure it's no big deal to go into debt because it only costs $52 a month. But the reason your payment is only $52 a month is because your bank is making you pay just 1% of the balance each month while also charging you an absurd 18% a year in interest.

Even if you keep paying $52 a month, it'll take over five years to pay off the entire $2,100, and you'll also end up paying over $1,100 in interest — more than 50% of what you borrowed in the first place. That, plus any fees your bank might charge you along the way, is the actual cost of your debt.

What's a better solution? If your credit is decent, open a new credit card with a 0% introductory interest rate on purchases. "Zero-percent offers can be an absolute godsend for folks in debt," explained Schulz.

You can review the top options in our guide to the best credit cards with 0% interest. The introductory rate on cards like these lasts between 12 and 20 months, which means during that time, the cost on your debt is $0.

But you'll need to be careful, because once the introductory period is over, the interest rate jumps to a more onerous double-digit rate. So you'll want a plan to get rid of that debt before it starts costing you a lot more. Which brings us to...

Rule No. 3: Create a debt repayment plan before you take the money

A major mistake that people make is taking on debt without a plan to pay it back. This happens a lot with credit cards. People spend more than they can afford with a credit card, then start paying only the minimum instead of paying off the balance in a timely manner, and soon enough, they're on a pace where it'll take years to pay it all back.

How do you avoid that fate? Before you take on any debt, make a plan as to how you're going to pay it back.

That means if you're using a 0% interest credit card to finance your debt, you're going to figure out how much you need to pay each month to get rid of most or all of it before the intro period ends.

"As a general rule, you should always pay more than the minimum payment on credit cards," said McClary. "The sooner you repay those debts, the more you will save in the long term."

Let's look at another example. If you have a credit card with any sort of balance on it, go grab your monthly statement and look for a box that looks like this one.

Your credit card statement shows how much your debt is costing you.

Federal regulations require every bank to have a box like this on its credit card statements so people can see how much their debt is actually costing them. This particular box is mine — I took advantage of a 0% balance transfer offer and consolidated $10,000 in debt to one credit card. I got charged a 2% fee, so my starting debt balance is $10,200, and I'll pay 0% interest for 12 months.

Now, this box shows that my bank wants me to make a minimum payment of $102 a month to start. But look at the part highlighted in red. If I only make the minimum payment going forward, it'll take me an insane 29 years to pay off this $10,000. And because my interest rate will jump after my introductory offer is over 12 months from now, it'll cost me almost $13,000 in interest over those 29 years.

Crazy, right? That's how debt can become insurmountable. But the solution is to make a plan to pay more than the minimum payment each month. In fact, the box itself shows what happens if, instead of paying just the minimum, I pay a higher $337 per month. If I do that, I'll pay off the entire $10,000 in just three years, and it'll only cost me a little less than $2,000 in interest.

But that's still a lot of interest, so I'm going to go even further. I'm making a plan to pay $500 a month on this debt. Because if I do that, I'll pay off $6,000 before my 12 months of 0% interest are over. At that point, I'll try to move the remaining debt to another credit card with a new 0% interest offer and pay down the rest of it that way.

Ideally, if you can afford it, you'll want to make a plan that pays off your entire debt during the introductory period. For this $10,000, that would come to $833 a month, which is pretty high, so I've compromised at $500 a month. Even at that rate, I'll be in much better shape 12 months from now because I'll only owe around $4,200, instead of the almost $9,000 I'd owe by paying only the minimum.

Related: Check out CNN Underscored's choices for the best balance transfer credit cards.

Yes, sticking to a plan takes discipline. It's easy to look at that minimum payment amount and think it'll be OK if you just pay that for now. You also need to budget for the extra amount each month, even if it'll be a stretch. But that's why you need to know the cost of your debt ahead of time, and make a firm plan for keeping that cost to a minimum.

Finally, if you find yourself struggling with debt, don't ignore the problem. "If your financial world has been flipped upside down by the virus, call and ask your credit card issuer for help," advised Schulz. "Issuers have so-called hardship programs that are made to help folks with short-term struggles that are not of their own doing."

And if the idea of talking to your bank makes you nervous, bring in reinforcements. "If it's difficult to deal with these issues on your own, seek free advice from a nonprofit credit counseling agency," said McClary. "A certified credit counselor can help you create a manageable budget while finding ways to affordably pay down your debt."

Use debt as a short-term fix, not a permanent crutch

You can use debt wisely to help you make it through these challenging times.

Normally, if your income is limited, it wouldn't be smart to fill in the gap with debt. But we're in an unprecedented economic crisis. If you recently lost your job or had your hours cut, it's reasonable to assume you'll be able to improve your income situation in the next 12 months. Going into debt during that time to help cover the gap isn't a perfect solution, but can work if you do it wisely.

When deployed carefully as a one-time fix, debt can help you get through tough times. But it's important to accumulate debt only for vital expenses, not luxuries; to know how much your debt actually costs; and to have a plan already in place to pay it off before you start. Follow these three rules and you can use debt as a tool to keep yourself afloat — without losing an arm and a leg.