Wise Debt Management and Budgeting
Wise debt management and budgeting are key components of healthy and effective financial planning and wealth management. Learn about the risks you should consider when taking on debt along with a variety of tips for sticking to your budget.
Presented by Tom Kennedy, CFP®:
Today, most people carry some amount of debt to finance a degree or buy a home or car. Other debts may be incurred out of necessity or as part of an investment plan. Whatever your reasons for taking on debt, you should understand the different types of debt and their risks. This knowledge will help you manage debt wisely as part of your overall financial plan.
Primary Types of Debt
The two primary types of debt are:
- Unsecured debt. Credit card balances and student loans are common types of unsecured debt. Typically, missing one or more of your monthly payments on unsecured debt could result in late fees, increased interest rates, damage to your credit score, and/or action by a collection agency. A delinquent borrower can also be sued by the lender.
- Secured debt. With secured debt, the lender has an interest in an asset, such as a home mortgage or car loan, or for those with high net worth, through a securities-based loan. In the event of default, the lender has a legal right to repossess its interest in the asset.
Risks to Consider
The distinction between unsecured and secured liabilities should not lead to conclusions about when debt is appropriate. Credit card balances and car loans, for example, are rarely part of a healthy financial plan, in part because assets acquired this way are subject to rapid depreciation. Furthermore, because unsecured debt is convenient, it can get out of control quickly. So, avoiding credit card debt and car loans is advisable unless you have a strict budget and the discipline to stick to it.
Other types of debt, such as mortgages and business loans, could increase your long-term net worth, provided the asset value increases or remains more valuable than the loan balance. In these cases, you have less risk of the debt getting out of control because secured loans can be fully satisfied by disposing of the secured asset. But the obvious downside is you could lose your home, car, or other valued asset. As a result, even if secured debt has lower interest rates and more favorable terms, you should carefully weigh the potential downsides before taking it on.
How Much Debt Can You Afford
With any type of loan, lenders decide what level of risk they will accept when making a lending decision. Factors they consider include credit history and the prospective borrower’s debt-to-income ratio. But the lender’s main concern is answering the question, “What is the maximum amount we can offer this borrower with the least likelihood they will default on the loan?”
It’s important to realize that a lender’s willingness to loan funds does not mean accepting the loan is prudent. When analyzing your ability to carry debt, consider your budget carefully and focus on the following:
- Liquidity. If you suddenly lost your job, would you have enough cash to cover your current liabilities? It’s a good idea to maintain an emergency fund to cover three to six months of expenses. But don’t go overboard. Guard against keeping more than 120 percent of your six-month expense estimate in low-yielding investments. And don’t let more than 5 percent of your cash reserves sit in a noninterest-bearing checking account.
- Current debt. Your total contractual monthly debt payments (i.e., minimum required payments) should come to no more than 36 percent of your monthly gross income. Your consumer debt—credit card balances, automobile loans and leases, and debt related to other lifestyle purchases—should amount to less than 10 percent of your monthly gross income. If your consumer debt ratio is 20 percent or more, avoid taking on additional debt.
- Housing expenses. Generally, your monthly housing costs—including your mortgage or rent, home insurance, real estate taxes, association fees, and other required expenses—shouldn’t amount to more than 31 percent of your monthly gross income. If you’re shopping for a mortgage, keep in mind that lenders use their own formulas to calculate how much you can afford. These formulas may not work for your situation. For a mortgage insured by the Federal Housing Administration, your housing expenses and long-term debt should not exceed 43 percent of your monthly gross income.
- Savings. Although the standard recommended savings rate is 10 percent of gross income, your guideline should depend on your age, goals, and stage of life. You should save more as you age, for example, and as retirement nears, you may need to ramp up your savings to 20–30 percent of your income. Direct deposits, automatic contributions to retirement accounts, and electronic transfers from checking accounts to savings accounts can help you make saving a habit.
Debt Pay-Down Strategies
If you’re carrying debt that exceeds what’s normal for the average household, we can discuss strategies to pay it down as aggressively as is reasonable. Here are two approaches to consider:
- Snowball debt elimination. This involves identifying lowest-balance debts and targeting them for priority repayment while making only the minimum payment on other items of debt. Once the lowest balance is paid off, move on to paying down a new set of lowest-balance debts.
- Debt avalanche. This strategy advocates paying off debts with the highest interest rate first. This makes mathematical sense but requires discipline and the ability to stick with the process.
Debt and Your Investment Plan
In some cases, you may believe that holding debt, such as a mortgage or margin investments, is beneficial. This idea is usually based on the potential for your investments to outperform the interest rate on the applicable loan and the investment opportunities you could explore with that extra liquidity.
For instance, you might believe that paying off a mortgage or margin loan could represent a tax-free return on investment essentially equal to the interest rate paid on the debt. But you would enjoy a significant net benefit only if the rate of return substantially exceeds the cost of the interest. And that result cannot be guaranteed. So, though this strategy could potentially yield a monetary benefit, the overall risk involved is significant.
Creating and Sticking to a Budget
Begin by creating a list of what you spend each month, and then separate it into categories. Necessities—housing, transportation, food, and utilities—come first. After these essentials, take note of your monthly debt payments. Car loans, student loans, and credit card invoices fall into this category.
Finally, you’ll arrive at discretionary spending or, in other words, the fun stuff: what you spend on entertainment, dining out, online shopping, and so on. Once you’ve written down all your discretionary expenses, compare them to your income. If you’re spending more than you’re earning, you should make changes.
- Ways to save. Being honest about your needs versus your wants can help close the gap according to the guide to budgeting. Do you need to pay for cable television, for example, when you are already subscribing to a variety of subscription-based networks? The best way to save is to bank a certain amount from each paycheck and act as if you never had it in the first place. Before long, your savings will grow, and you’ll be less tempted to dip into them.
- Track expenses. Keeping track of monthly expenses used to be a tedious chore, leaving little wonder why people failed to stay on budget. Today, however, there are apps that do all the heavy lifting for you. Mint is a great example. The Mint app puts your entire financial life in one place and notifies you when bills are due, so you’ll always know where you stand.
As your income and goals change, so should your budget. Adjusting your budget to accommodate your needs is a skill that will prove beneficial throughout your career.
Budgeting for the holiday season
Good intentions often get derailed with increased spending at the holidays. You may also allow economic turmoil or upswing affect your goodwill. Instead of letting the headlines guide your budget, write out an actual breakdown of your income and expenses to see what you can afford. Some good rules of thumb to follow include:
- Pay with cash during the holiday season. Inflation is making it more difficult to afford necessary goods and services, so Americans are increasingly relying on credit cards. But interest rates are also going up. So, unless you pay off your balance in full, you’ll ultimately be spending way more on your holiday gifts than the sticker price. To keep your spending in check, and to avoid tacking interest payments onto the cost of your purchases, pay with cash—or be sure you can pay off your entire credit card balance. While using a debit card is an alternative option, be warned that this method puts you at greater risk for cybercrime. If your account number is somehow stolen, it’s much easier for a scammer to quickly access your money, and there are fewer consumer protections with a debit card than there are with a credit card.
- Shop sales. Keep an eye out for sales, coupon codes, and free shipping perks before making a purchase, especially at big box stores. Overstocked products will also find their way to off-price retailers as larger stores sell off their excess and delayed shipments that arrived late. If you’re looking for a specific gift, compare that item at various retailers to make sure you’re getting the best deal available.
- Buy off-season. While most people are focusing on pumpkin spice and sweater season, stores are hoping to get rid of whatever swimsuits, beach towels, and pool floats they still have in stock. If you can suspend your summer mindset for a few more weeks, you could score significant deals on gear for next year. Remember this tip at the end of winter, too, when prices of cold-weather attire are similarly slashed.
Need Additional Information?
We’ll talk through these strategies for managing debt and creating a budget and explore other planning solutions that can help you stay or get on track to financial security. To get you started on the discussion, check out our additional articles for budgeting and financial tips. By carefully approaching debt and budgeting with a detailed plan on how much to borrow, how to repay your debt, and how to live within your means, you can reach your goals and support your long-term financial success.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. Third-party links are provided to you as a courtesy and are for informational purposes only. We make no representation as to the completeness or accuracy of information provided at these websites.
Tom Kennedy is a financial advisor located at Global Wealth Advisors 520 Post Oak., Suite 450, Houston, TX 77027. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial network®, Member FINRA / SIPC, a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors are separate and unrelated to Commonwealth. He can be reached at (832) 649-8111 or at email@example.com.
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