Financial Planning 101 series - Debt Management
Updated: Jan 29, 2020
Welcome to 7th Street Financials series of original content on financial planning. The goal of this series will be to help educate you on a wide number of topics related to your financial wellbeing. Today I continue with a deeper dive into the base of the financial pyramid, specifically debt management.
Debt is something that almost all of us live with whether it is having a mortgage, car loan or credit cards. Debt can be used smartly or it can become a crippling financial burden if it gets out of control. The focus of this article will be to review some popular thoughts on debt that will hopefully give insight on your own personal situation.
When you think about your monthly income it is broken down into several buckets. We have taxes, savings, debt, bills (utilities, gym, insurance, cell phone, internet, etc..), food/household supplies/clothing and other miscellaneous expenses. Some of these are fixed and some we have some degree of control over. Those that we have some control over are considered more discretionary in nature. This is where most of our fun money goes. We can use this for travel, entertainment, hobbies, go out with friends, decide to spend extra on food or clothes or whatever it is that will make you happy. And, really besides providing basic life necessities, isn't that we want money for is to be able to do things that make us happy?
If debt is managed properly and is appropriate with your income levels and net worth then you increase your chances to have that desirable discretionary income. The problem with debt is that if not managed properly and held in check the mandatory payments needed to be made on debt start to squeeze out the money that can be used on those fun discretionary items. If it gets worse, then you start squeezing out other important areas like savings.
How can debt be so harmful? Our installment debt like mortgages and auto loans have a set duration and payment each month. As long as we maintain these payments we pay off the loan and at the end we own the asset the loan was attached to. Other consumer debt like credit cards though don’t have a fixed amount and tend to carry much higher interest rates. There is no end date to paying off a credit card. You just keep paying until the balance is zero. And just like the power of compounding of interest is the most powerful tool for building wealth it is also one of the most powerful tools towards ruining it. As debt accumulates and you can’t pay it off the interest amount being charged to you grows which increases your balance which further reduces your ability to pay the bill which means more interest and you are in a vicious cycle of mounting debt that you can’t afford to pay off.
So, let’s take a look at some popular debt calculations and see how they impact your financial health.
1. Net Worth – This is simply your assets less your liabilities. At a bare minimum we never want this number to turn negative. You may very likely have a negative net worth though very early in your working career as you have just begun saving money and probably don’t have much in the way of real assets but might have credit card or student loan debt. This is a number that should grow over time as you continue to save, your investments grow and you pay down your debts especially the big ones such as a mortgage. There is no magic number that this needs to be for each individual but make sure this number is positive and continues to grow at a steady pace year over year.
2. Current ratio – This measures your current assets against current liabilities. Current assets are your assets that can be quickly converted to cash (basically your assets less home, cars, personal property and retirement accounts) and current liabilities are those owed within one year. The ratio divides the current assets by current liabilities. So if you have cash of 10,000 and investments of 50,000 you would have current assets of $60,000. Now compare to liabilities such as a credit card balance of $5000, car loan payments of $6000 during the next year would leave you with current liabilities of $11,000. Taking the assets of $60,000 divided by the $11,000 of liabilities leaves you with a ratio of 5.5. This ratio should at minimum be 1 and anything over 2 is considered good.
3. 36% debt payments – This guideline states that all of your monthly debt payments should be less than 36% of your monthly gross income. Your gross income is all of your income including the amount withheld for taxes, employment benefits and retirement plans. For the debt part include all components of your house payment (principal, interest, taxes, insurance, PMI) in addition to all other debt payments.
This ratio is used by those in the business of lending money. They have a vested interest in getting you to borrow as much as you can reasonably afford. Personally, I think allocating 36% to debt payments is too high. Take a family making $120,000 per year which is $10,000 per month. Let’s account for 25% ($2500) of income going to taxes and they are saving 12% ($1200) in retirement. Add in 36% ($3600) going to debt and you have 73% ($7300) of the family income accounted for and you have only $2700 left to pay for bills, food, household supplies, and discretionary expenses. Maybe that is enough but health insurance, childcare, children’s activities and other expenses can cut into that amount pretty quickly. I would shoot for a target of 30% as a more manageable goal.
4. 28% mortgage payment - This guideline states that all components of your house payment (principal, interest, taxes, insurance, PMI) not exceed 28% of your gross monthly income. Again, this ratio is used by those as a target in the lending industry who want you to take on debt. Let’s use our family again that is making $120,000 per year or $10,000 per month. By this measure this level of income would be okay to take on a $2,800 per month house payment. In today’s interest rate environment that would allow for a $500,000 house providing a 20% down payment or a $400,000 mortgage.
Now, if we say 36% for total debt is ok, that would allow only $800 total to account for all other debt payments including credit cards, auto, student or other personal loans. You can see this could start to get tight pretty quickly. If you take my previous recommendation of keeping total debt at 30% you would have only $200 for non-mortgage debt.
I am a firm believer in buying what you can afford now and not assuming your income will grow by leaps and bounds so that you end up buying something you are projecting being able to afford. You have probably heard the term “house poor” and that’s how people get in that situation. The lender is willing to give you enough money to buy the house that technically they say you can afford but the reality is that with your other life expenses you aren’t left with much else. You end up not being able to maintain the house, do the improvements you envisioned when you first bought it, or do the other fun things you want to in life.
I would shoot for a target of 20% for mortgage payment. This might be disappointing to those wanting the bigger fancy house but it will leave you with much greater financial flexibility in your life. This would allow our family making $10,000 per month to buy a house with a $2000 monthly payment which equates to a $350,000 house providing a 20% down payment. Given the previous 30% overall debt recommendation that leaves $1000 monthly for non-mortgage debt.
5. 15% of take home pay for consumer debt – This guideline dictates that no more than 15% of your net take home pay should be allocated to non-mortgage debt. For our family making $10,000 per month let’s use our previous numbers of 25% for state and federal taxes and then 12% for savings. This leaves $6300 of net take home pay of which about $950 could be allocated for non-mortgage debt.
You can see that some of these ratios really need to be used together as alone they can be misleading. Our family might be feeling good about things with 15% of consumer debt and let’s say 25% of mortgage debt but combine them and it might be too much debt to carry comfortably. Likewise, someone might be at the high end of the mortgage ratio but they might live very fugally otherwise with no credit card debt and maybe live in an area where they utilize public transportation so aren’t burdened with an auto loan and overall be okay from a debt perspective.
Also, these numbers will vary depending on your career cycle. Young people early in their careers may have student loan debt and not much in the way of assets. Their biggest asset is their earning potential and over time should get the numbers to look better. A person in their mid 40’s still struggling to get a positive net worth is in a much more dire situation comparatively.
Lastly, let’s discuss the impact of debt in retirement. Income is retirement is viewed as fixed to a certain extent. Social Security benefits are fixed and you have to figure out how to make your retirement savings last. There are no more raises, promotions or bonuses you can count on to get you out of financial trouble. It’s not that you can’t have debt in retirement. Many people still have a mortgage or car payments but those can quickly cut into your income. Again, using our family who had income of $120,000 while working might have $4000 in combined Social Security benefits and if they saved 12% a year could withdraw another $4000 monthly from retirement savings. This might sound like a very nice retirement, and it certainly can be, but after $2000 in taxes and then if we assume a $2000 mortgage, $500 car payment and $500 per month in credit cards they are left with $3000 per month for all other living expenses including travel and medical costs which can be significant in retirement. If debt can be retired before retirement or early in retirement you can see the amount of money that gets freed up for discretionary spending.
To recap, debt is a necessity for most of us and if kept under control can be used to help us purchase things of value at a reasonable cost. Be very careful about what lenders tell you that you can afford. You need to know for yourself how much debt you are comfortable with and still be able to have money for the other things you want in life and not rely on someone whose business it is to get you to borrow as much as possible. Try to keep your overall debt burden to less than 30% of your gross income. The individual amounts of consumer and mortgage debt percentages can vary based on how much of one type you have compared to the other but a rough guideline would be 20% on mortgage and 10% on consumer debt.
Debt that is allowed to get out of control can have devastating consequences. If you feel that things might be slipping away please take action as soon as possible to reign it in. Ignoring the issue will only make it worse but by taking early corrective action you can get your financial life back in order.
Thank you for reading and stay tuned for the next installment where I will begin to discuss
various types of insurance and how important it is to mitigate financial risks.