Episode 295: December 11, 2012
Debt Loans Credit
by Laura Adams
Debt is a powerful tool that allows you to finance large purchases, manage your cash flow, or even start your own business. But how much debt is too much?
In today’s episode we’ll discuss where to draw the line so you know when you’ve crossed over into reckless financial behavior. I’ll cover 7 warning signs that indicate you may have too much debt that could jeopardize your financial future.
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How Much Debt Is Too Much?
Debt is a complex topic because people have very different opinions about it. Some insist that no amount of debt is acceptable—even a home mortgage.
Some believe that having a mortgage is okay, but borrowing for a car or making purchases on a credit card is a financial mistake. Others believe that any type or amount of debt is alright, as long as you can afford the payments.
Lenders have guidelines about how much debt borrowers should have. For instance, in the mortgage industry, the typical requirement is that your house payment can’t exceed about 30% of your monthly gross income. And the total of all your debts, including the mortgage payment, generally shouldn’t add up to more than 40% of your gross income.
When Should You Go Into Debt?
My stance is that you should only go into debt when:
you’re confident that you’ll receive a return on your investment
you have steady income or ample savings to make payments
you qualify for a competitive interest rate
For instance, financing an affordable home at a low interest rate allows you to build wealth over the long term if it appreciates or is less expensive than renting. Getting a student loan for an education gives you the ability to earn more over your lifetime. And financing a reliable vehicle allows you to get to work on time and be a dependable employee.
Why Debt Can Hurt Your Personal Finances
The problem with debt is that it puts unnecessary strain on your finances that keeps you from making positive progress, such as building an emergency fund, investing for the future, and reaching your financial goals.
Never go into debt for anything that doesn’t give you a return—like consumer goods, dining out, or fancy vacations. Financing those types of purchases, especially on a high-interest credit card, causes you to lose wealth instead of build it.
7 Warning Signs That You Have Too Much Debt
Never go into debt for anything that doesn’t give you a return—like consumer goods, dining out, or fancy vacations.
Sometimes we don’t realize that our finances are out-of-control until it’s too late. However, here are 7 warning signs that you may have too much debt and need to take quick action:
Warning Sign #1: You Don’t Know What You Owe
If you don’t know how many debts you have or their approximate balances, you need a reality check! Take the time to create a spreadsheet listing each account name, number, interest rate, and amount owed.
In general, it’s best to tackle debts with the highest interest rates first, such as payday loans and credit cards, since that gives you the most potential savings.
Warning Sign #2: You’ve Been Turned Down for Credit
If you’ve recently been denied credit, you probably have low credit scores. Poor credit can be the result of one or many factors, such as having late payments, judgments, liens, too little credit history, or too much debt.
To learn more about how credit scores are calculated and how to raise your credit, read or listen to the podcast version of 7 Essential Rules to Build Credit Fast.
Warning Sign #3: You Don’t Have Savings
If you don’t have savings, you’re living on the edge, financially speaking! Any unexpected expense could send you into a tailspin that causes you to go further into debt.
Make a plan to radically cut your expenses and begin setting aside as much as possible each month in an emergency fund at an FDIC-insured bank.
Warning Sign #4: Your Credit Cards Are Maxed Out
If you’re using credit cards to satisfy a shopping habit or to buy necessities during a financial rough patch, you’ll eventually hit your credit limit.
Having a maxed out credit card really hurts your credit and may cause you to incur fees if a purchase exceeds your credit limit. Stop making charges or taking expensive cash advances on maxed out cards and start making payments that are higher than the monthly minimum.
Warning Sign #5: You Don’t Pay Bills On Time
If you’re not paying bills on time, it could be because you’re extremely unorganized. But it’s more likely that your finances are a mess and you don’t want to face them.
Ignoring bills may make you feel better in the short term, but I promise that they will come back to bite you in the form of late fees and bad credit. Contact your creditors to discuss any financial hardship and ask for their help. You may be able to work out a payment plan to get caught up with past due balances or have late fees waived.
Warning Sign #6: You Overdraw Your Bank Account
I don’t know too many people who have never accidentally bounced a check—even me. However, if you’re paying expensive non-sufficient funds (NSF) fees on a regular basis, it’s probably because you’re spending more than you make.
The cure for this problem is to create a budget so you know what your expenses are and how much you earn. Then cut back on variable expenses that change from month to month, like groceries, dining out, and entertainment.
Warning Sign #7: You Lie About Your Finances
If you’re lying to family or friends about your spending habits or how much debt you have, it’s because you know deep down that there’s a serious problem. If you’re worried, losing sleep, and having trouble concentrating due to debt, it’s time to take action.
Create and stick to a realistic budget, make an appointment with a financial planner, or see a debt counselor. The National Foundation for Credit Counseling at nfcc.org is a great resource.
The only way to improve a bad situation is to be brave and face it head on. Denying a debt problem only makes it worse and prolongs your agony! The sooner you address it, the sooner you’ll make positive financial changes.
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Debt Reduction photo from Shutterstock.