The market upheaval in the third quarter of 2008 kicked off more than the Great Recession. It spurred Americans to get a handle ontheir major financial obligations. Household debt payments in the United States, as a percentage of personal disposable income, were 15.75 percent at the end of the third quarter of 2012. That is a steady drop since the third quarter of 2008, when the rate was 18.2 percent.
But do lower debt levels indicate that Americans have learned how to safely use credit to support their financial goals? “Lending, borrowing and financing are absolutely critical parts of the economy and of a personal financial plan,” says Adam Holtzschue, head of Lending & Banking Services at Wells Fargo Advisors. “But you must use credit sensibly and within your means.”
For most of us, it’s not feasible to avoid debt entirely. In some cases, such as taking out a mortgage to finance a large purchase over time, borrowing money might be smarter than spending cash. Here are guidelines to help you understand how to use credit wisely and maintain a reasonable balance between your cash flow and debt.
Your debt ratio
Smart credit use starts with knowing how much personal debt you can reasonably carry from month to month. Holtzschue offers a few benchmarks you can measure your debt against.
Generally speaking, you shouldn’t be paying more than 30 percent of your gross income monthly for your mortgage payment, Holtzschue says. Your total debt payments – including mortgage payments, credit cards and other loans – shouldn’t total more than 40 percent of your gross annual income. Operating above or below those general guidelines may sometimes be appropriate, depending on your income level, your confidence in its continuity, the level of your cash reserves and other factors. A financial advisor can help you calculate your debt-to-income ratio and discuss ways to make more informed credit decisions.
It often makes sense to borrow money for a large asset purchase, such as a home or a college education. And you can avoid liquidating investment assets that are part of a carefully constructed plan or might create unnecessary tax consequences if sold. In fact, low interest rates are making financing an even more attractive option for many consumers. but low rates or low monthly payments should never be the sole reason you take on debt. You have to be confident in your ability to repay the loan. If your income varies greatly from year to year or if you are uncertain about the stability of your job, you may want to reconsider taking on a long-term loan.
Is it worth the debt?
Before you make a purchase, compare the length of the loan with the useful life of the asset. You don’t want to finance something for longer than you intend to own or use it, Holtzschue says. If you find yourself stretching the length of a loan just to get to an affordable monthly payment, consider putting off the purchase until you’ve saved more for the down payment.
Keep reserves intact and plans on track
Sometimes larger purchases are made using savings or by liquidating investment assets such as stocks or bonds. But it might pay to pause and reconsider this strategy, especially if you can borrow money at interest rates that are lower than the expected return on your investments. That way, you keep cash reserves intact for unexpected expenses and preserve your long-term investment strategy. Be sure to work closely with your financial advisor to weigh your options in these situations.
Using credit cards wisely
Best prices for managing your credit are different when it comes to revolving debt, such s credit cards. “Credit cards are an excellent tool to bridget cash flow for transactional purchase that can be repaid quickly,” Holtzschue notes. “But they are not as valuable as a tool to finance longer-term assets.”
Carrying a large balance on one card – or small balances on many cards – for a long period of time could be a sign that excessive debt is about to overwhelm your finances. To determine whether you’re at risk, add up all our credit card balances and combine that total with your other outstanding loans. Then compare the total debt with your gross income to see whether you’re still within the safe debt-toincome range.
Be sure to examine the new disclosures on your credit card bills that show how long it might take to pay off your balance. If you can’t pay down those balances within a few years, it’s time to reach out for help from the experts, including your financial advisor and lenders. These knowledgeable professionals can help you develop a plan of attack to tackle that debt.
And don’t get discouraged. As Holtzschue says, “The most important decision you can make is the decision to have a plan.”
This article was written by Wells Fargo Advisors and provided courtesy of Todd Alexander, The Alexander Financial group in McConnellsburg.
Investment products and services are offered through Wells Fargo Advisors Financial Network LLC (WFAFFN), and Member SIPC. The Alexander Financial Group is a separate entity from WFAFFN.