What Should You Not Use a Loan to Purchase?

Using loans for certain purchases can lead to significant financial difficulties. Responsible borrowing focuses on ensuring the acquired item or investment either retains or increases in value, or generates income, thereby justifying the incurred debt.

Purchases That Lose Value Quickly or Are Consumed

Financing items that rapidly depreciate or are quickly consumed often creates a financial imbalance, where the debt obligation far outlasts the utility or value of the purchase. This situation can lead to negative equity, meaning you owe more than the item is worth. Such purchases can become financial burdens, especially when coupled with interest payments.

New cars exemplify this issue, as they typically lose a significant portion of their value the moment they are driven off the lot. An average new car can depreciate by approximately 20% in its first year alone, and up to 60% within the first five years. This rapid loss in value means a car loan can quickly result in owing more than the vehicle’s market worth, making it difficult to sell without incurring a loss. Consumer electronics, like smartphones or televisions, also experience fast obsolescence and declining value, rendering them poor candidates for long-term financing.

Similarly, discretionary items such as fashion, clothing, and luxury goods generally do not retain their purchase price. Luxury items often depreciate, and financing them with high-interest credit can significantly increase their actual cost over time. Borrowing for experiences like vacations or large celebrations, such as weddings, also falls into this category. The average wedding cost in the U.S. can range from $33,000 to $36,000, and financing such an event means paying for a memory long after it has passed, without any tangible asset or financial return.

Speculative Investments

Using borrowed money for speculative investments carries substantial risk due to the inherent volatility and uncertainty of returns. If the investment performs poorly or fails entirely, the borrower is left with the original debt plus interest, without the anticipated financial gain to cover it. This can amplify losses and lead to severe financial distress.

Penny stocks, for instance, are high-risk investments characterized by their low price, limited trading volume, and often a lack of reliable company information. Their speculative nature means prices can fluctuate wildly, leading to rapid and significant losses. Newer cryptocurrencies also exhibit extreme price swings and are considered a highly volatile asset class, making them unsuitable for borrowed capital.

Starting a highly risky business venture with borrowed funds presents another speculative scenario. The failure rate for new businesses is considerable, with approximately 21.5% failing in their first year and nearly half failing within five years. Should the business not succeed, the entrepreneur remains responsible for the loan, potentially facing personal bankruptcy. These types of investments compound the inherent risk of the venture with the additional burden of debt repayment.

Existing Debt

Taking out new loans to pay off existing debt, particularly without a comprehensive strategy for debt reduction, can be a dangerous cycle. This approach often addresses the symptom rather than the root cause of financial struggles, potentially increasing the overall debt burden and prolonging repayment. Such actions can create a precarious financial situation where short-term relief leads to long-term problems.

Payday loans or title loans, for example, are short-term, high-interest options that can trap individuals in a cycle of debt. These loans often carry annual interest rates ranging from 300% to 500%, making them far more expensive than traditional bank loans or credit cards. Using one high-interest loan to pay off another merely shifts the debt and can lead to accumulating more interest and fees.

Similarly, using credit cards to pay off other credit cards often increases overall debt and interest payments. While debt consolidation can be beneficial if it involves a lower interest rate and a disciplined repayment plan, it carries risks such as upfront fees, a temporary negative impact on credit scores, and the temptation to accrue new debt on freed-up credit lines. Without addressing underlying spending habits, consolidating debt can simply delay or worsen financial difficulties.

Daily Living Expenses

Borrowing money to cover routine, recurring daily living expenses is a strong indicator of a fundamental budget deficit or insufficient income. This practice is unsustainable because these expenses reoccur, leading to a rapid accumulation of debt without any corresponding asset or long-term benefit. It signals that an individual is living beyond their means and can quickly spiral into a debt trap.

Using high-interest loans, such as credit cards, for groceries, utility bills, or rent payments means that these consumed items or services become significantly more expensive due to added interest. For instance, if credit card interest rates hover around 20% APR, routine purchases financed this way can quickly inflate the total amount owed. This creates a situation where a portion of future income is perpetually allocated to repaying past consumption, making it harder to meet current expenses.

Financing discretionary items like entertainment or dining out with borrowed funds further exacerbates this problem. This approach does not build assets or provide long-term financial stability; instead, it generates debt for transient pleasures. Relying on credit for basic necessities can also negatively impact one’s credit score through high utilization rates or missed payments, hindering future access to more favorable lending terms.