Planning Your Financial Endgame

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The best way to manage debt is to not have any debt. This is usually not practical, especially when we are younger. As we get older, we tend to have more disposable income.

If you do not have unmanaged debt, congratulations, this chapter is optional for you.

Owing money isn’t always bad. Paying your bills when they’re due can help you build and improve your credit history.

Debt is bad when you owe money you can’t pay back. You might have legal problems if you can’t pay back the money. Or debt collectors might call you.

Know how much debt you can afford

The key to managing debt is taking on only as much as you can afford to repay. You do not need to get caught up in the math details below, just know that these metrics exist and are used to determine debt servicing capabilities.

One way to determine what is affordable is to determine your debt-to-income ratio. To calculate this metric, tally all your minimum monthly debt payments -- including your mortgage or rent and student, auto and other loan payments -- and divide the total by your pre-tax monthly income. The result will be in the form of a percentage.

While there are no absolutes in determining desirable debt-to-income ratios, the following are general guidelines for how lenders evaluate potential borrowers:

·         Excellent - 30% or less

·         Good - 30%-36%

·         Borderline - 37%-40%

·         Red Flag - 40% or more

Example:

Your gross income (before taxes) is $6,000/mo. and you have a mortgage of $1,400/mo. and a car payment of $600/mo. Your ratio would be 33%.

Keep the 28/36 rule in mind when purchasing a home

The 28/36 rule is a way that lenders calculate the debt a potential homebuyer can reasonably take on. Under this guideline, a household should spend no more than:

·         28% of their pre-tax monthly income on housing expenses (including mortgage, insurance and taxes)

·         36% of their pre-tax monthly income on all debt payments (including housing)

Example:

Your gross income (before taxes) is $7,083/mo. and you have a mortgage of $1,400/mo., insurance and taxes 390/mo. and a car payment of $600/mo. and a credit card debt payment of $100. Your ratio would be as shown below.

Good debt and bad debt

Like many things, debt is complicated. Too much debt can be a problem for some people, yet it can also help you reach your financial goals provided it’s managed responsibly.

Good debt

Characterized as low-interest debt that helps you increase your income or net worth. Examples include educational loans, a mortgage or a business loan. Debt can also be considered good if it helps you build credit.

Bad debt

Characterized as high-interest debt that is used to purchase depreciating assets. Examples include using credit cards to buy clothing, furniture, or other goods that immediately lose value -- then not paying off the balance and building up interest charges.

Of course, too much debt can turn good debt into bad debt. And many kinds of debt don’t fall into either category and depends on your financial situation or other factors.

Be smart about credit cards

Credit cards offer a host of benefits. They’re convenient. They build a credit history. And they can be a helpful tool for tracking your spending. Most credit cards also provide various security features, including liability protection for fraud or even travel and rental car protection.

For all their benefits, however, credit cards are a less-than-ideal way to borrow money, as they carry high interest rates on any balances you don’t pay off right away. To avoid those high fees, here are a few debt management tips:

·         Only charge what you can pay off each month.

·         Keep your monthly charges to 20% or less of your maximum credit limit.

·         Always pay your bill on time.

Debt impact on credit score

Sometimes, debt can hurt your credit history. For example, it might hurt your credit if you:

·         Owe a lot of money on credit cards

·         Pay bills late

·         Don’t pay the minimum amount due

·         Skip payments

 

Set a goal to pay off all credit cards and revolving credit lines.

Create a budget

If you are carrying debt, you can develop a budget based on your income and expenses to help ensure that you can afford all your monthly payments. Then, you can work toward identifying which debt you should pay down first and allocate your extra funds toward that debt. You can use the Budget Worksheet in this book to create a budget.

Write down how much money you make every month and how much you spend. You might find ways to spend less money. You can then put the money you save toward paying off your debt.

Next, call the companies you owe money to. Call the company before it sends your debt to a debt collector. Explain why you’re having trouble paying your bill. Ask for a payment plan. Some companies might let you pay less every month until you’ve repaid all the money.

Make extra payments

To pay off your debt quickly, you’ll need to pay above the amount due each month. This extra amount will go directly toward the principal and reduce the total amount owed.

Here are a few techniques to achieve this:

Avalanche method

With this approach, you make the minimum payments on all your debts each month, then direct any remaining money toward whatever debt has the highest interest rate. Once that debt is paid off, you apply the extra cash toward the debt with the next-highest interest rate, and so on -- until all your debts are gone. By tackling your highest interest debt first, the avalanche method reduces the total interest you will pay on your debts -- and the amount of time it will take you to get out of debt. However, it requires discipline and a consistent level of discretionary income.

Snowball method

With this approach, you make minimum payments on all your debts, then direct any extra money each month toward your debt with the smallest balance. When that debt is paid off, the money previously allocated toward the old debt is “snowballed” into paying off the next-smallest debt, and so on -- until all your debts are gone. This method provides motivation by achieving quick debt-reduction “wins.” However, it may take longer than the avalanche method -- and may not reduce as much of the interest you’ll pay.

Pay biweekly instead of monthly

By making biweekly payments, you’ll pay half your monthly bill every two weeks instead of making one full monthly payment. This means you’ll make an extra payment each year, reducing your repayment timeline and the amount of interest you’ll pay. Not all lenders will allow this method.

Swap high-interest debt for lower-cost loans

Debt consolidation -- or combining multiple debts into a single, larger debt, usually at a lower interest rate or longer term -- can be another avenue to manage debt.

Some options for consolidating loans include:

Personal loans

Use personal loans to pay off all your other existing debts. This allows you to swap high-interest debts for a single loan with a lower, fixed interest rate and a fixed monthly payment.

Borrow against retirement

Tap into securities-based lending to borrow against a portion of your non-retirement investment portfolio as collateral. This can provide cash to help cover expenses or pay off debt while keeping your investment portfolio and strategy intact.

Home equity loan

Take out a home equity line of credit (HELOC), to use the equity in your house for other purposes. Once you establish your line of credit, you can access the funds to pay down high-interest debt. However, while this strategy can reduce interest, your home is used as collateral, meaning that if you don’t repay the debt, the lender has claim to your home.

Renegotiate with lenders

Creditors can be more flexible than people assume. Some are willing to negotiate with customers looking to lower their interest rates, create a payment plan or make accommodations to help better manage their debt. Sometimes, you just need to ask.

Look for extra income

Earning more money is another way to help pay off debt faster. You can do that by picking up more work, taking on an income-generating “side hustle” or finding a new job that pays more.

Dedicating any extra cash toward your debt can also help. If you receive extra money in the form of a tax refund, an annual bonus or monetary gift from a loved one, consider allocating all or part of it toward your debt.

Sell off assets

If you’re contending with high-interest debt, it may make sense in certain scenarios to liquidate some assets to pay off your obligations faster. For example, if you own a car with a high resale value, it may make sense to sell the vehicle, purchase a less expensive car and use the remaining proceeds to pay off the high-interest debt.

Know when it makes sense to prioritize investing versus paying off debt

The psychological benefits of being debt-free are undeniable. However, if you’re behind on your retirement savings or if you have an especially low interest rate on a mortgage loan, it may not be beneficial -- from a pure numbers standpoint -- to prioritize paying off your debt, compared to the returns you could make in the market. Additionally, certain debts -- such as mortgages, home equity loans and student loans -- offer tax benefits, so be aware of how that dynamic affects your overall financial picture.

It will depend on your unique situation and goals. For some, the sense of freedom that comes from no loan balance is worth more than the potential returns had they invested. Reflect on your priorities, run the numbers and be comfortable with any tradeoffs you’re making.

Make sure you have a cash reserve

Even if your priority is paying down your debt, consider setting aside a portion of your monthly income for a cash reserve or emergency fund. This pool of money can act as a cushion, potentially preventing you from getting deeper into debt if you face an unexpected expense.

Balance debt with your other long-term goals

Whether you’re rethinking how to manage your current debts or considering taking on new loans, an Ameriprise financial advisor is prepared to provide personalized advice unique to your situation.

 

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