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Controlling
Debt
Controlling
Debt
Good
debt vs. bad debt
Does it
make sense to borrow, a lot of times it doesn't
Many
of us let debt get out of hand. Ideally, experts say, your total
monthly long-term debt payments, including your mortgage and credit
cards should not exceed 36 percent of your gross monthly income. That's
one factor mortgage bankers consider when assessing the
creditworthiness of a potential borrower.
It is far too easy to spend more than you can afford, especially when
you pay by credit card. The average U.S. household with at least one
credit card has an $8,523 balance, according to CardWeb.com, and
personal bankruptcies have hit record highs in recent years.
Of course, avoiding debt at any cost is not smart either if it means
depleting your emergencies cash reserves. The challenge is learning how
to judge which debt makes sense and which does not? Then wisely
managing the money you do borrow.
In cases where debt makes sense
Good debt includes anything you can write-off at the
end of the year! For example: obtaining advance education, if you don’t
have enough cash on hand to pay for the classes. Taking out a school
loan would be a tax write-off. If you have a business and need some new
equipment, you could take out a loan and this could be a write-off!
Only take loans for which you can afford the monthly payments.
Bad debt includes debt you've taken on for things
you don't really need and can't afford (that trip to Bora Bora, for
instance). The worst form of debt, of course, is credit card debt,
since it carries the highest interest rates. Spending money you don’t
have can put you in the "poor house" real fast! And of course, your
next step would be bankruptcy!
Sometimes the decision to borrow doesn't hinge on how much cash you
have but on whether there are ways to make your money work harder for
you. If interest rates are low, compare what you'll spend in interest
on a loan versus what your money could earn if it were invested. If you
think you can get a higher return from investing your cash than what
you'll pay in interest on a loan, borrowing a small amount at a low
rate may make sense.
What you should know
about debt
1.
Americans are loaded with credit card debt.
The average American household with at least one credit card has $8,523
in credit card debt, and the average interest rate is 15 percent,
according to CardWeb.com.
2. Some debt is good.
Borrowing for a home or college usually makes good sense. Just make
sure you don't borrow more than you can afford to pay back, and shop
around for the best rates.
3. Most debt is bad.
Don't use a credit card to pay for things you consume quickly, such as
meals and vacations. There's no faster way to fall into debt. Instead,
put aside some cash each month for these items so you can pay the bill
in full. If there's something you really want but it's expensive, save
for it over a period of weeks or months before charging it so that you
can pay the balance when it's due and avoid interest charges.
4. Time to change your spending habits.
Most people spend thousands of dollars without much thought to what
they're buying. Write down everything you spend for a month, cut back
on things you don't need, and start saving the money left over or use
it to reduce your debt more quickly.
5. Pay off the highest rate debts first.
The key to getting out of debt efficiently is to first pay down the
balances of loans or credit cards that charge the highest interest,
while paying at least the minimum due on all your other debt. Once the
high interest debt is paid down, tackle the next highest, and so on.
6. Don't pay just the minimum.
By just paying the minimum due on your credit card bills, will barely
cover the interest you owe, to say nothing of the principal. It will
take you years to pay off your balance and potentially you'll end up
spending thousands of dollars more than the original amount you
charged.
7. Don’t borrow against your investments.
It may be convenient to borrow against your home or your 401(k) to pay
off debt, but it can be very dangerous. You could lose your home,
and/or fall short of your investing goals at retirement.
8. Plan for the unexpected.
Start working towards a cash cushion worth three months to six months
of living expenses in case of an emergency. If you don't have an
emergency fund, a broken furnace or damaged car can seriously upset
your finances.
9. Paying the mortgage off quick may not be in your best
interest.
Don't pour all your cash into paying off a mortgage if you have other
debt. Pay off all other debt first! Mortgages tend to have lower
interest rates than other debt, and the interest you pay is tax
deductible. (If your mortgage has a high rate, then consider
refinancing.)
Managing your debt
Easy steps put you, not your
bills in charge
Outside
of fixed monthly bills such as your rent or car payment, you probably
don't have a precise idea of how you spend most of your money. If you
want to get your debt under control, start by figuring out your
spending patterns and identifying unnecessary expenses.
Each
month, write down every cent you spend. And by "every" we mean "every,"
including that $2 cup of coffee that starts your workday or that $4
magazine you buy on a whim. That will clarify in black and white how
much of your spending is fixed and how much is variable.
Tally that list and compare it to your monthly income. How much do you
bring in after taxes? And how much do you have left at the end of the
month after paying fixed expenses? Consider, too, whether there's any
way to boost your take-home pay.
(If
you receive a big tax refund at the end of every year, that means
you're having too much withheld from your paycheck. If that's the case,
you can reduce your withholding by changing your W-4 at work).
Next, make a list of all your debt obligations that you pay out each
month. By doing this, it will give you a clearer picture to where all
your money goes each month! You will be amazed at some of the foolish
spending habits you might have?
The basics of debt reductions are simple: Cut down on your variable
spending and put the extra money toward your debt payments. Once you
determine the maximum amount you can pay off each month, pay down the
debt with the highest interest rate first. That usually means your
credit card balance, while paying at least the minimum monthly amount
due on all other revolving bills.
Once
the debt with the highest rate is wiped out, put your money toward
paying the debt with the next highest rate. One exception: If
you have a credit card with a low teaser rate that will go up after a
fixed amount of time, strive to eliminate that balance before the low
rate expires.
With Credit
Cards You might also consider moving some of your high-interest
credit card balances to one card with a lower interest rate.
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But read
the fine print on any invitation to transfer balances.
Sometimes such low-interest-rate offers are only in effect
for short periods of time, after which the rate skyrockets.
What's more, consolidating your debt on one card may lower
your credit score if your debt-to-credit ratio worsens. If
you have more debt than you can manage, get help before your
debt breaks your back. |
Try the Consumer Credit Counseling Services,
MyVesta.org or other
reputable debt counseling agencies
For many people, reining in discretionary spending for a few months
goes a long way toward tackling debt. But if that's not enough, try to
reduce your fixed expenses. Take steps to lower your household bills;
refinance your mortgage to get a lower interest rate; or, if you have a
good payment history, ask your credit card company to lower the
interest rate you're charged. Credit card companies will usually lower
your interest rate every 6 months, but you have to ask them! They won’t
do it automatically.
Three examples of
good debt
Home, school and your chariot qualify
Purchase
of a home. The chance that you can pay for a new home in cash is
slim. Carefully consider how much you can afford to put down. And the
amount of your monthly payment. The more you put down, the less you'll
owe and the greater your chances of getting a lower mortgage interest
rate.
Although it may seem logical to plunk down every available dime to cut
your interest payments, it's not always the best move. You need to
consider other issues, such as your need for cash reserves and what
your investments are earning. Also, don't pour all your cash into a
home if you have other debt. Mortgages tend to have lower interest
rates than other debt, and the interest you pay is tax deductible. If
your mortgage has a high rate, you can always refinance.
A 20 percent down payment is traditional and usually helps buyers get
the best mortgage deals. But many homebuyers put down less - as little
as 3 percent to 5 percent in some cases. Those who do, however, pay
higher monthly mortgage bills and a higher interest rate. They also pay
for primary mortgage insurance (PMI), which protects their lender in
the event they default.
For more on financing a home, read: Buying
a home.
Paying for college. When it comes to paying for your
children's education, borrowing makes far more sense than liquidating
your retirement fund. Your kids have plenty of financial sources to
draw on for college, but no one is going to fund your retirement except
you. What's more, a big 401(k) won't count against you if you apply for
financial aid since retirement savings are not counted as available
assets.
It's also unwise to borrow against your home to cover tuition. If you
run into financial difficulties down the road, you risk losing the
house.
Your best bet is to save what you can for your kids' education without
compromising your own financial health. Then let your kids borrow what
you can't provide, especially if they are eligible for a
government-backed Perkins or Stafford Loan, which are based on need.
Such loans have guaranteed low rates; no interest payments are due
until usually 6 months after graduation; and interest paid is tax
deductible under certain circumstances.
For more on educational financing, read: Saving for College.
Financing your new car. Figuring out the best way to
finance a car depends on how long you plan to keep it, since a car's
value plummets as soon as you drive it off the showroom floor. It also
depends on how much cash you have on hand.
If you can pay for the car outright, it makes sense to do so if you
plan to keep the car until it dies or for longer than the term of a
high-interest car loan or pricey lease. It's also smart to use cash if
that money is unlikely to earn more invested than what you would pay in
loan interest.
Most people, however, can't afford to put down 100 percent. So the goal
is to put down as much as possible without jeopardizing your other
financial goals and emergency fund.
Typically
you won't be able to get a car loan without putting down at least 10
percent. A loan makes most sense if you want to buy a new car and plan
to keep driving it long after your loan payments have stopped. Or if
you are going to be driving it for business purposes, where you can
write it off!
You may be tempted to use a home equity loan when buying a car because
you're likely to get a lower interest rate than you would on an auto
loan and the interest is tax deductible. But before you bet the Farm,
make sure you can afford the payments. If you default, you could lose
your home. If you do opt for a home equity loan, be sure to pay it off
while you still have the car say, no more than five years. (3-4 years
would be better).
Leasing a car might be your best bet, if the following
applies:
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You want a new car every three or
four years.
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You want to avoid a down payment
of 10 percent to 20 percent.
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You don't drive more than the
15,000 miles a year allowed in most leases.
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You keep your vehicle in good
condition so that you avoid end-of-lease penalties.
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And your are able to write it off
at the end of each year!
Whatever
route you choose, shop for the best deals. Remember that it's in the
car dealer's best interest to finance at the highest rate possible! So
look at what you'll pay overall, not just the monthly amount. If you
tell your car dealer you can spend $400 a month, you could end up with
a new car for $400 a month based on an uncompetitive interest rate.
For more on auto financing, read: Buying
a car.
When is it wise to
borrow, to pay off your expenses?
A
home-equity loan is smart in some instances
Besides
life's big ticket items, a home, car and college, you may be tempted to
borrow money to pay for an assortment of other expenses such as
furniture, appliances and home remodeling.
Generally speaking, it's best to pay cash up front for furniture and
appliances, since they don't add value to your home and are
depreciating assets. If you do finance such purchases, however, read
the fine print. Retail stores often charge high interest rates. And
even if they offer a low-interest or no-payment period for several
months on a purchase, you may be required to pay for the item in full
at the end of that period or risk being charged a high rate dating back
to the day of sale.
Taking a home equity loan makes sense if you're making home
improvements that increase the value of your house, such as adding a
family room or renovating your kitchen. The interest you pay is
deductible and you increase your equity. If you have any money left
over after paying for the improvements, then go ahead and pay off that
new dishwasher, oven or fridge.
But, if you don’t plan on doing any home improvements to your home,
then don’t take out a loan just to pay off your bills! It just doesn’t
make sense!
Controlling
Debt
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