Manage Your Debt and Avoid Money Troubles

Good Debt, Bad Debt

Stories like the one above are not at all unusual. But not all debt is created equal. Some kinds of debt are actually OK:

• Your mortgage. Your home loan may very well be your biggest debt. But the interest you pay on your mortgage provides you with a tax deduction. Plus, over time you typically build equity in your property, which can be leveraged via a home equity loan or line of credit.
• Your student loans. Could you have gotten where you are in your career without your degree? Would you be earning what you are today without having gone to college? As burdensome as they can be, your student loans are probably worth every bit of work it takes to repay them. (And student loan interest may also be tax deductible.)

Some debt to minimize:

• Your auto loan. If you need a car and can't afford to pay cash, you'll need an auto loan. On the bright side, successful repayment of a significant debt like a car loan will help you build a positive credit record. Nonetheless, try to repay your car loan as quickly as your budget allows.
• Credit card balances. Credit can be a great financial tool, but with interest rates sometimes exceeding 20 percent, be careful how you use it. Typically, credit card debt becomes a problem when it takes you longer than three months to pay off your purchases.

How Much Debt Is Too Much?

A good rule of thumb is that your debt-to-income ratio (all your outstanding monthly debt payments including rent or mortgage) divided by your monthly gross income should not exceed 36-40 percent. For example, if your gross monthly income is $5,000, your total monthly debt payments (including rent or mortgage) shouldn't be more than $2,000. Most lenders will use this equation in deciding whether to extend you credit (though some lenders allow a larger debt-to-income ratio than others).

Ultimately, the appropriate amount of debt for you is what you feel comfortable with, not what any lender says you can afford. If debt keeps you awake at night or keeps you from reaching your other financial goals (like saving for retirement, buying a home or paying for your kids' education), then you've got too much debt. The less indebted you are to others, the more freedom you have.

Commit to Getting Out of Debt

Follow these guidelines for designing, and sticking to, a debt management plan:

1. Decide to do it. If your debt weighs you down and causes you stress, then commit to change things.
2. Create a plan. Create a budget so you know where your money goes and then devote all extra funds to paying down debt. Start with the debt that carries the highest interest rate first. Once you've paid that off, devote the extra money to the next highest-rate debt, and so on. As you pay off the balances, you may want to consider closing unnecessary accounts.
3. Change your habits. If you're a compulsive shopper or have a particular weakness (restaurants, jewelry, electronics), recognize it and make every effort to change the behavior and avoid temptation. Once you're out of debt, it will take ongoing effort to stay there.
4. Assess your situation. Keep track of your spending and your credit card balances every month. Look at your credit report to be sure it is accurate. Will it be a barrier to buying a car, a home or refinancing? Order copies of your credit report from each of the three credit reporting bureaus (Equifax, Experian, and TransUnion), as each may have a different version. The Fair and Accurate Credit Transaction Act (FACTA) allows for all consumers to receive a free copy of their credit report from each of the three credit reporting bureaus every 12 months. Reports can be ordered through www.annualcreditreport.com or by calling 877-322-8228. You will not be able to receive a free report by contacting the credit bureaus directly. (Unless you have been denied credit based on information obtained by a lender from the credit bureau.)
5. Stick to your plan. Making the decision to get out of debt is half the battle. If you stay committed, you'll succeed.