Monday, November 2, 2009

Get Smart About Debt

Money Magazine recently published a brochure about dealing with debt. According to the material, rule number one of debt management is to borrow only when it makes financial sense.

During the boom you barely had to be breathing to qualify for loans. Too many people leveraged themselves silly. By 2007, U.S. households owed $1.33 for every $1 of disposable income. With so much debt, many people couldn't cope when their mortgage rates reset or they lost their jobs.

Before you take on debt, make sure you won't get into a similar situation. First look at your debt-to-income ratio, or your monthly debt payments divided by your monthly pretax income. You want to stay under 30%. Next consider why you're borrowing. Limit borrowing to "good debt," which finances something likely to retain or gain value. Examples are a mortgage or a student loan. Low interest rates and tax benefits are other signals that taking on "good debt" makes sense. Using credit for a vacation or a 50-inch TV? Clearly not financially wise.

Here is a quiz to help determine whether borrowing would be wise:

-Will the investment add to your net worth over time?
-Is the loan's interest tax-deductible?
-Is your credit score high enough that you'll qualify for the lowest available interest rate?
-Will your total debt payments remain less than 30% of your pretax monthly income?
-Can you afford the payments if you are out of work for six months?
-Can you prepay the loan without penalty?

If you answered yes to five or six questions, borrowing may make sense. If you only answered yes to three or four questions, borrowing may not be wise, and if you answered yes to two or less questions you should probably forget the idea now...

Of course, debt management is a primary function of financial planners. Actually, discussing debt management is a great way to determine whether a financial planner has your best interest in mind. Many so-called "financial advisors" encourage their clients to take on more debt in order to afford the products the advisor is selling. This is a huge red flag, and if your advisor is doing this you should run. It is best to speak to an independent fee-only financial advisor who accepts a fiduciary responsibility to act in the clients best interest. These financial planners will help clients manage their debt, not create new debt in order to create a paycheck for themselves.

1 comment:

partner program said...

Yeah its very good if you have a partner in financial specially if its about debts.