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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

3 Important Ways (A Little) Debt Can Actually Help Your Finances

Editor's Note: This article was updated August 26, 2013.

Imagine a country where everyone owns everything outright -- cars, houses, fishing boats, flat-screen TVs. There are no mortgages and no credit card balances in this imaginary land.

Does it sound like heaven? Perhaps. But in economists' terms, it's hell.

These days, Americans aren't in debt heaven or hell; it's more like purgatory because of the changing debt landscape since the dawn of the Great Recession. Consumer credit increased at a seasonally adjusted annual rate of 6% in the second quarter of 2013, the Federal Reserve reported. Revolving credit only increased at an annual rate of 2%, while nonrevolving credit increased 7.5%. In June, consumer credit increased at an annual rate of 6%.

Let's say credit saw a drop. Let's say you and your neighbor didn't owe anything on your cars, house or flat-screen TV.

But would 0% be ideal? No, and here are three reasons why.

1. Credit -- and the debt that follows -- lets people buy houses, invest in their business and make other purchases they couldn't have otherwise. The old saying, "It takes money to make money," still applies, and a bit of debt can help. They can buy supplies that can help them start their own home business. They can buy a home that they can start building equity in. They can send their kids to college.

And an economy that lets people buy things is a healthy economy. "Developed economies depend on the expansion of credit," said Daniel S. Hamermesh, a professor of economics at The University of Texas at Austin. What worries him more than the level of debt is interest rates; too high means less borrowing and less ability to buy, he points out.

But the fact is that all developed, or "rich," countries have some debt, "even Switzerland, that paragon of thriftiness," Hamermesh said.

2. Debt helps you establish a credit rating and a credit score. One financial fact of life is that to prove credit worthiness, you have to borrow money and pay it back. The trick is to do it wisely, said James Poe, chairman and founder of Texas Retirement Specialists, a Fort Worth-based financial planning firm. The key, he said, is to manage your debt ratio, which is the sum of your total debt-reduction payments divided by your after-tax income.

For instance, if you take home $3,000 a month, and each month, you write $1,000 in checks to your creditors, your debt ratio is 33%. "The lower the figure, the better," Poe points out. "The higher the number, the less credit you will be granted." Indeed, a debt ratio of 50% or higher raises a red flag to prospective creditors.

3. Debt can help you maximize your credit score once you establish it. Consumers sometimes don't have a choice of what kind of debt they take on; if they have a good credit rating, they get favorable terms, including low interest rates. Those who don't are left with high interest rates. One playing-field leveler: The ability to pay off debt. Make sure you make every monthly payment, avoid interest rates and late fees, and voila, watch your credit score rise, Poe said.

The Investing Answer: Debt makes sense for a healthy economy -- and a healthy portfolio. And current conditions are favorable for folks looking to borrow.

But always remember: No matter how good the rates are, you should never take on more debt than you can afford. That's simply asking for trouble.