I would like to be DEBT FREE. i would like to clap my heels together three times, and say, "there's no better feeling than being debt free," and then, be debt free. But, of course, it just doesn't happen that way. Under the recent Bankruptcy Abuse and Prevention Act of 2005, even going into bankruptcy will not allow you to become debt free -- you may not even be able to discharge your "bad debt." Thus, you should start thinking right now about how much bad debt is too much and how to get rid of it.
What is "bad debt?" Most financial advisors make a distinction between debt that allows a person to meet long-term goals and debt that is used for consumer spending. The latter, the debt used for consumer spending, is generally seen as bad debt. That means that it is debt that a person should attempt to avoid, and, if you already have it, get rid of it before getting rid of the debt that acts as an investment toward future goals.
Debt used to finance a home purchase, education and a well thought out business or investment plan, such as buying rental property, is "good" debt. Recognizing the value of this debt, the federal government rewards some of it by making it tax deductible. A car fits into both the good and bad debt category as does a home equity loan or line of credit. If the car is necessary and moderately priced, you may have no choice but to go into debt to fund it. And a home equity loan or line of credit used to add value to your home (for maintenance and repair) could be good debt while a home equity loan or line of credit used to pay off credit cards and/or to finance consumer purchases or unnecessary renovations to your home is basically bad debt (even though it is tax deductible and should certainly be used to pay off such debts if possible). And leasing a car is always a bad debt (if it is a personal car, not a business car) because usually people lease cars that they otherwise could not afford.
All other debt is bad debt and ideally, we would have 0% of bad debt in our financial statements. The goal ought to be to spend only what you can afford for consumable items; however, the average American carries more than $8000.00 of such debt, so, how much is too much is a good question to ask even if our goal is to eliminate it all.
How much "bad debt" can you really afford? Several personal finance books create a method of calculating your debt load. Excluding your primary mortgage, student loans and business loans, you can calculate your remaining debt against your income to get a percentage of debt to income. i have seen two different methods of calculating your debt load:
1) Take your monthly debt payment total it for the year. Divide it by your take home pay for the year and you will have your debt to income ratio or total debt load. So, if you make $50,000 per year net (take home) and you pay $1000.00 for car loans, home equity lines of credit, credit cards, etc., your total yearly "bad debts" equal $12,000.00. $12,000 is 24% of $50,000.00 ($12,000 divided by $50,000 = 24%.)
2) The second method is to add all of your debt and divide it by your annual income. Thus, instead of monthly payments and net income, we divide total debt by gross income. So, let's say the person has a $75,000 income and bad debts of $25,000. Obviously, in that situation, the debt is actually 33% of the income.
Why does it matter?
A lot of people do not really understand why it matters if they maintain credit card and other bad debts as long as they can afford the monthly payments. Just because you can afford the payments now does not mean that you will be able to in the future. Plus, the interest payments that you make is money that could be better put to other uses than repaying something that you have already consumed.
The more debt you have, first of all, the less likely you are to be able to actually afford it. if more than 20% of your income goes toward repaying debts for items that you have already consumed, another 30% - 40% at least, probably goes toward paying off your "good" debts. That leaves only 50% of your income for your non-debt bills, like utilities, insurance, child-care, groceries, grooming, clothing, gas, etc. After all of that, what is left for pure discretionary spending let alone emergencies or other savings?
On the other hand, If that 20% is still in your pocket, you can afford more of the niceties of life and can also afford to save both for emergencies and for larger expenses, like down-payments on houses, cars, vacations, weddings, college, retirement, etc., as well as for some luxuries (a nicer car, clothes, a boat, or beach house perhaps?)
If you pay for every item when you buy it, it costs a lot less than using a credit card that you pay off only the minimums every month. In fact, if you have bad debt of $8500.00 and pay off only the minimums, you actually will pay for that debt for 29 years and, assuming an 11% interest rate, you will have basically payed double that $8,500.00 over the life time of the loan.
While the overall debt load can affect your long-term financial health, the debt to income ratio affects your cash flow. When that ratio is 20% or more of your income, you probably have too much debt and must consider using every resource you can think about to reduce and eliminate that debt. You can find a good method for eliminating that debt in "Eliminating Debt."
Remember that your goal is to get to zero of the bad debt. That means you have to be disciplined in your spending. You have to decide to wait to buy something until you can afford it. That is difficult to do, but we have been living that way for the past 4 months approximately. We spend far less money than we used to and have eliminated two of our worst debts on the hierarchy of debt: store cards, and are now working our way through our high interest credit cards one card at a time. We have not changed our lifestyle that much, and we feel much more in control over our money. If we continue to be disciplined, we will have met our goal of eliminating our bad debt within about 3 years, which feels like a long time, but it will free up so much money that we do not feel deprived, we feel good. We have everything we really need and can still afford the occasional treat, but we are staying focused on the goal of getting rid of our debt for good.
Also, the more debt you can eliminate, the better your credit scores will be allowing you to get better interest rates on necessary debt. One of the major aspects of credit scores is how much available credit you have: if you are maxed out on your credit cards, that is a negative in your score. Thus, although you want to eliminate debt, you do not want to necessarily close the accounts that you had because the score will increase if you show that you have available lines of credit that you do not use. (For a more thorough explanation of how the credit scoring process works, see "How to Take Control Over Your Credit.")
What should you do?
The fact of the matter is that no matter how high your debt load is, anything above 0% will sometime catch up to you and cause you to regret your earlier wastefulness. Many items are not necessary; thus, saving for them ahead of time gives you an opportunity to reflect on their value. Popping out the credit card may give us immediate satisfaction but will not give us the long-term financial stability that we need. You may find yourself, one day in the not too distant future, wondering how come you cannot afford to buy something that is important or to fix something that requires fixing in your home or even getting a "good" loan because your bad debt has overwhelmed you.
That may be the first time you realize that the amount of such debt is very harmful to your financial health. You may end up living like you are poor -- if you have a high income, you can afford more debt than if you have a low income, but the ratio must stay reasonable. If it exceeds 20%, than you actually are "poor" even though you have a good income. If you are having trouble motivating yourself to get rid of the bad debts, calculate their amount. Just the sheer number -- $1000.00 per month out of 4200.00 take home (assuming a $50,000.00 income) is a lot of money for value that you received earlier.
The other problem with bad debt is that it compounds into other money problems and makes it very difficult for you to deal with regular bills. Once you are in too deep, you will have trouble finding the extra money necessary to start paying off your debt rather than just paying monthly minimums for your debt. When it exceeds 20% of your salary, and you have other debt, you really will have trouble paying for unexpected expenses or saving for upcoming big expenses. Then you will regret having paid for so many items on credit because you really can't afford it.
If you find yourself in that situation, you need to consider all of your options. If you are consistently living above your means, you have to reduce your spending or increase your revenue: there is no other way out. Bankruptcy is one of the options that those who are in too deep might consider; however, the new bankruptcy laws protect the credit card companies and ensure that you pay them off eventually even if it is a bit more slowly. So, bankruptcy is a last resort: it is expensive to file for bankruptcy and, under the new laws, far fewer people will actually get the "fresh start" that they may think bankruptcy will give them.
Credit counseling is another option if you cannot create your own plan of debt management. However, you should be sure to work with a reputable company who can offer you a valuable service: spending money to decrease your debt is only worthwhile if you do not have the ability or desire to spend the time to do it on your own. Many of the companies actually get fees from the lending institutions and, therefore, may not tell you that you need to file for bankruptcy to get rid of the debt.
Some of the credit counseling agencies will put you on a debt management plan. That is a system where you pay the money to the agency and the agency doles it out to your creditors according to arrangements that they make with the creditors. You need to be especially vigilant when you are offered such an arrangement: first, you must make sure the company is legitimate. There are people who will offer such services, take your money and not pay your debt. And, even if they are legitimate, they are often paid by the lending institutions; thus, they may not get you the best deal you could get or even suggest that you are in need of bankruptcy protection. If you do go with a credit counseling agency, try to avoid their debt management plans; just get their advice and do the work on your own. If you do not feel you are disciplined, put yourself on an automatic payment plan with your creditors: get on line and use an auto pay system.
If you do decide to you credit counseling, check out the name of the agency offering its services with the Better Business Bureau in the state in which they are licensed and in your own state. Check the FTC web site to see if they have any complaints against them. Also, put their full name into Google: see what other people say about their programs. Their are probably some good programs out there, but you must do your homework to find them and ensure they are legitimately helping debtors and not just taking your money.
Do not, however, allow desperation to cause you to do anything rash to get out of your situation. There are a million scams out there to get quick loans; checks and credit card offers come in the mail all the time and you may think that they are the answer to your problems. I have been reading a lot about "scams" lately, and most people who are defrauded by these schemes are defrauded because of a lack of knowledge, desperation or greed. If your debts are overwhelming, don't look for the answer in some get rich quick scheme or some loan that will get you out of your debt if you pay an "up-front" fee. The November issue of Money Magazine had an excellent article on scams related to money. Take a look at that before you agree to anything that will make you feel less desperate. (4 Scams: How to Avoid Them).
Stop the Madness Now
So, put a stop to your bad debt now. Check out how high your debt load is using one of the two methods above. If it is above 0%, you should work to reduce it, but if it is above 20%, you MUST work to reduce it before the bad debt controls your finances. Put away your credit cards especially when you are shopping: use a debit card or cash to keep control over your spending. Decide which card to pay off first, and send more than the minimum monthly payment every month until it is paid off: than work on the next card. If you can, find a lower interest way to get out of all the debt and just pay that off: a home equity line of credit may be cheaper than your credit cards; however, the danger of transferring debt is that you may get into increasingly more debt. Only transfer debt to lower interest cards if you will actually pay off the old card and put it away for good.
Try to build a reserve of cash that you can use to ensure that you can deal with financial emergencies without borrowing to fund them. Many of us get "extra" money once in a while: think about putting that away instead of spending it so it will be there when you really need it. If you get paid every week, four times a year, you get an extra check -- put it away or use part of it toward your debt load and part of it for emergencies.
Keep yourself focused. That's the most important thing. If you are aware of your financial situation, you can better deal with it. Knowledge is power. Figuring out your bad debt may not feel good, but it can be the best way to take control over your money.