Although it’s almost impossible to live debt-free, a simple rule of thumb is that your total monthly long-term debt payments, including your credit cards and mortgage, should not exceed 36 percent of your gross monthly income.
It’s far too easy to spend more than you can afford, especially when credit cards are used for payments. Avoiding debt at any cost is not a smart move either if it means depleting your cash reserves. You should maintain three to six months of living expenses built into your cash cushion in case of an emergency.
Debt is not always a bad thing. In fact, there is good debt and bad debt.
Some good debt:
- Borrowing for a home or college usually makes good sense. Just make sure that you don’t borrow more than you can afford to pay back. Shopping for the best rates helps keep your payments to a minimum. Home mortgages tend to have lower interest rates than other debt, so you would not want to pour all of your cash into paying off a mortgage if you have other debt. Also, with mortgages you can deduct the interest paid on the first $1 million of the mortgage loan.
- Taking a home equity loan or home equity line of credit makes sense if you’re making home improvements that increase the value of the house. However, if a home project won’t boost your house value then consideration should be given to paying cash or taking out a short-term, low-interest loan that will be paid off in five years or less.
- Borrowing for your children’s education and allowing them to take out student loans makes far more sense than liquidating or borrowing against your retirement plan or borrowing against your house. The best bet is to let your kids borrow what you can’t provide without compromising your financial health.
Debt to avoid:
- Borrowings that would be considered “bad” debt include debt that is taken on for things that you don’t need and, in turn, can’t afford. This type of debt is usually credit card debt, and it usually carries the highest interest rates.
- Borrowings through your credit cards for things that are consumed quickly, such as meals and vacations, usually lead to major credit card debt if these amounts cannot be paid off each month.
- The key to getting out of debt efficiently is first to pay down the balances of loans or credit cards that charge the most interest while paying at least the minimum due on all of the other debt.
If you want to get your debt under control, start by figuring out your spending patterns and identifying unnecessary expenses. The basics of debt reduction are simple. Cut down on your variable spending and put the extra money toward your debt payments. For many people, reining in discretionary spending for a few months goes a long way toward tackling debt.
Answer by: Paul Block, CPA, Albanese Sinchar Smith & Co., North Huntingdon, Pa.