KEY TAKEAWAY: Debt can be a useful financial tool when managed properly, but it can also become a burden creating stress and obstacles to working toward our financial goals if not carefully considered. By understanding your financial situation, evaluating the cost of debt, and exploring alternatives, you can make informed decisions and prevent debt from negatively impacting your financial well-being. Scroll down to the TAKE ACTION section for this week’s actionable steps.

Debt is a financial tool, and at one point or another, most of us have chosen or will choose to use it to fund some purchase. Whether that is in the form of a home mortgage, auto loan, student loan, or a product or service that we charge to our credit card, debt is part of most of our financial journeys.

However, like many tools, it can be positive or negative.

Some debt can support greater future wealth or income, such as a home mortgage that allows us to invest in a home that not only shelters us but may also go up in value over time or a student loan that enables us to build our education and skills to support our future income potential. Other debts support our current living, such as an auto loan that gives us access to and from our work. Even credit cards can serve a positive purpose by providing a convenient way to pay for products and services.

However, debt can turn negative when we take on so much debt that it becomes unmanageable, creating financial stress and an obstacle to working toward other financial goals.

For example, we may buy a home with a mortgage that is such a high portion of our income that we have little leftover income for other things and are “house poor.” We may take on so many student loans that the amount we have to pay back when we graduate and start working is formidable and makes it challenging to work toward other goals, such as saving for a future home or retirement. We might use our credit cards not just as a convenient payment method but to purchase things we can’t afford or to supplement our ongoing living costs so that our monthly balance owed balloons over time.

The latter is a situation that most of us would prefer to avoid. Therefore, before we take on new or more debt, the following are some things to keep in mind to help ensure that debt doesn’t go from being a tool that works for us to one that works against us and creates considerable financial and overall stress in our lives.

TIP #1: KNOW YOUR WHY

In other words, what is the purpose of the debt you are considering? Why are you contemplating taking on this financial obligation?

Need vs. Want: Is the debt necessary? For example, is it for an essential home repair or medical service? Or is it more a discretionary purchase, such as a vacation you would like to take or a material item you want to buy? Ask yourself:

If I do not take on this debt, will it negatively impact my essential quality of life or financial stability?

Long-Term Impact: Consider how new debt will impact you long-term. How will it affect your ability to work toward your other financial goals in the short-, medium-, and longer-term? Will it help you achieve your goals or hinder your progress? Will it provide a future benefit or cost? Ask yourself:

How will taking on this debt affect my ability to achieve my other short-term and long-term financial goals?

TIP #2: UNDERSTAND YOUR CURRENT FINANCIAL SITUATION

Assess where you stand financially right now. What is your financial picture?

Net Worth: Your Net Worth is Your Assets — Liabilities. What is your current net worth? Where do you stand now in terms of your assets (what you own) and liabilities (what you owe)? Take stock of your current debt, including the balance owed, the interest rate you pay, your monthly payments, and, if applicable, the timeframe for paying off the debt.

Cash Flow: How is your cash flow? How are you currently balancing what you earn and your ongoing financial obligations? Do you have enough cash flow to cover your current living expenses and other financial obligations, including debt you may already have?

Rainy Day Fund: As part of this, look at your savings. Do you have a Rainy Day or Emergency Fund to provide some buffer to cover your debt obligations if you experience a drop in or loss of income? Do you have additional funds to take care of unexpected expenses that might come up with resorting to more debt? Generally, it is recommended that you have enough in your rainy day fund to cover at least three to six months of living expenses, adjusted as appropriate to fit your circumstances.

Credit Score: How is your current credit score, and how would taking on additional debt impact it? Your credit score impacts not only your access but also your credit cost. The better your credit score, the more able you can access credit and secure better interest rates and terms. Two major drivers of your credit score are credit utilization — how much of your available credit you are currently using — and your credit history — or how well you have paid your financial obligations on time.¹ So, how might your access to and cost of credit be impacted if you take on the debt you are considering?

Ask yourself:

Do I have a clear understanding of my monthly income, expenses, and existing debt obligations, and am I able to comfortably manage my current financial commitments?

TIP #3: EVALUATE THE COST OF DEBT & YOUR ABILITY TO REPAY

Cost of Debt: What are the terms of the debt you are considering? What is the interest rate on the debt? Is it compound interest — where interest is charged on any unpaid balances — or simple interest — where interest is calculated based on the original amount borrowed? What is the repayment period and schedule? Are there penalties for early repayment? Check out the many online calculators to help you answer these questions. I’ll include some resources in the references below.

Your Ability to Repay: Based on the cost of credit and your current financial situation, can you afford the additional monthly payments? Check your current cash flow statement and your Money Plan (a.k.a “budget”) if you’ve done one. Do you have enough funds to cover the additional payments associated with the debt you’re considering?

Also, how stretched will you be if you take on more debt? There are two checks you can do to help assess this. One focuses on housing debt, and the other focuses on total debt.

Check #1: Given your income, is your spending on housing reasonable?

Add up your average monthly non-discretionary housing-related expenses (i.e., mortgage payment, including principal and interest, property taxes, insurance, and association fees).² Then, divide that total by your average monthly gross income (so before taxes or other deductions), and then multiply by 100 to get a percentage.

Generally speaking, if your result is 28% or less, then your housing costs are likely manageable for you, given your income.¹ If it’s > 28%, you may be stretched too far.

Note: If you’re renting, the general rule is not to spend more than 30% of your gross pay on rent.²

Check #2: Given your income, is your total debt obligation manageable?

Add your average monthly housing costs — the same as you used in Check #1 — plus any other recurring debt payments.² For example, these would include the following:²

• Mortgage payment, including principal and interest
• Property taxes
• Homeowners Insurance
• Homeowners association fees
• Legal obligations, such as child support or alimony
• The minimum required debt payments on credit cards and other loans

Divide the total you get by your average monthly gross income (again, gross income is before taxes and other deductions. Then, multiply that by 100 to get a percentage.

Generally speaking, your debt level is probably manageable if your result is 36% or less .² If it’s > 36%, you might be stretched thin or unable to meet all your debt obligations regularly.

Keep in mind that lenders consider these checks, so understand how the debt you are considering could impact your creditworthiness for future loans.

TIP #4: EXPLORE ALTERNATIVES

What alternatives do you have vs. taking on the debt you are considering:

Delay: If the debt you are considering is driven more by want vs. need or if it’s non-essential to being essential, and if your current financial situation doesn’t support taking it on, then take it off the table, whether for the time being until your financial situation will support it or indefinitely.

Budget Adjustments: Look for ways to cut expenses and reallocate funds to cover the new expenses.

Use Savings: Does it make sense to use savings instead of debt? If you have savings you could tap, how would doing so impact your ability to achieve your other goals now and in the future?

TIP #5: MOVE FORWARD WITH CARE

Shop Around: If you decide to proceed with the debt obligation, compare offers from different lenders, including banks, credit unions, and online lenders. Look for special promotions or discounts that may lower the cost of borrowing.

Understand the Terms: Make sure you fully understand the terms of the debt obligation, including the interest rate, repayment schedule, and any fees. Be aware of any penalties for paying late or paying off the debt earlier than planned.

Have A Plan: Build the new debt payment obligations into your Money Plan (a.k.a. “budget”). If you want to pay down the debt earlier, create a plan to do so, building additional payments into your Money Plan.

TIP#6: GET HELP IF NEEDED

Are you unsure of what to do? Consider consulting a finance professional, such as a financial planner, to get personalized advice based on your financial situation and goals. Consider speaking with a credit counselor for guidance on managing debt effectively.

FINAL THOUGHTS

In conclusion, your financial well-being impacts your overall well-being, and part of supporting both is to manage debt effectively. So, before you take on new or additional debt, take into account the above tips.

Remember: The more informed you are, the more informed choices you can make. It is also better to go into a decision with eyes wide open, especially when it is one that can carry with it financial obligations and the emotional stress that can go along with that. So do your due diligence before you sign on the dotted line.

TAKE ACTION:

REFERENCES:

1: Credit

Credit Education. MyFICO. Retrieved from https://www.myfico.com/credit-education

Credit Reports and Scores. USA.gov. Retrieved from https://www.usa.gov/credit-reports

2: Housing and Total Debt Checks

WellsFargo.com. Common Questions About Debt-to-Income Ratios. Retrieved from https://www.wellsfargo.com/goals-credit/smarter-credit/credit-101/debt-to-income-ratio/dti-faqs/

Kagan, Julie (2021, November 29). What Is the 28/36 Rule? Investopedia. Retrieved from https://www.investopedia.com/terms/t/twenty-eight-thirty-six-rule.asp#:

Nowacki, Lauren (2022, January 13). What Percentage of Your Income Should Go to Mortgage Payments? Retrieved from https://www.quickenloans.com/learn/percentage-income-mortgage

Sheehy, Kelsey (December 6, 2022). How much should I spend on rent? Retrieved from https://www.nerdwallet.com/article/finance/money/how-much-should-i-spend-on-rent

RESOURCES:

Credit Card Payback: https://www.calculator.net/credit-card-calculator.html

Home Down Payment Calculator: https://www.calculator.net/down-payment-calculator.html

Rent vs. Buy Calculator: https://www.calculator.net/rent-vs-buy-calculator.html

Mortgage Payoff Calculator: https://www.calculator.net/mortgage-payoff-calculator.html

IMPORTANT: The information provided is for educational and informational purposes only. It is not intended to be a substitute for professional advice, diagnosis, or treatment. Always seek the advice of a qualified professional with any questions you may have regarding the topics discussed here as the topics discussed are based on general principles and may not be applicable to every individual. 

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