It may fall outside the realm of ObamaCare, but it is a good idea to give your collective debt an end of the year checkup. Consider which debt is healthy and which debt may be showing symptoms of chronic conditions that will attack your bank account and put you in poor financial health.
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For this examination, you get to be the doctor! Don’t worry – we are here to help as your trusted assistants. Remember two things: debts without significant return and high-interest-rate debts are usually bad.
Just as a doctor would examine different systems in your body individually and then see how they work as a whole, we will do the same with individual debts and then consider your cumulative debt.
Mortgage Debt – Mortgage debt is usually the best form of debt, as you are building up equity in your home and gaining an appreciating asset. However, if mortgage debt pushes your cumulative debt too high, it can be considered bad debt. Just as with your body, healthy things can become unhealthy if pushed beyond moderation.
Educational Debt – Again, educational debt is considered an investment because it should help you get a higher-paying job – but it is not guaranteed. It is very hard to get a student loan discharged or forgiven, so if you don’t get a job proportionate to the expense, student loans can be a very bad debt. Nobody wants to think about that aspect as he or she enters college, but the return is important. You might be able to get scholarships or go to a different college that should produce a similar return for less cost if this is a concern for you.
Installment Debt – Installment debt for big-ticket items such as automobiles, appliances, and entertainment devices may be good or bad depending on the need of the item, the interest rate, and the installment terms. Typically, interest on this type of debt is high, so you should pay installment debts off early if you can. As to whether it is good or bad debt – you generally know, even if you won’t admit it to yourself. Did you need to buy a Porsche vs. a Prius? Did you need a 75” flat screen TV with Surround Sound vs. a smaller, simpler model? Do you even need a TV at all? Only you can balance the value to you compared to the debt you incur.
Credit Card Debt – Credit card debt is almost always bad debt unless you never charge more than you can pay off each month. Cash-back programs can help, but they don’t cover the charges for carrying a balance. Credit card debt is the Pop-Tart of the debt world – very tempting, never really good for you, harmless in small amounts, and bad in excess.
Short-Term Loans – Payday and title loan debts are never, ever, healthy because of the sky-high interest rates. If you are afflicted with short-term, high-interest loans, quickly go to the nearest financial emergency room for credit counseling.
Cumulative Debt – Calculate your monthly debt-to-income (DTI) ratio, just as if you were preparing to buy a home. DTI is all of your liabilities (debt obligations, not your living expenses) divided by all of your pre-income tax. Between 36% and 43% is considered higher risk for a home purchase – if you are in this range or higher, you have too much debt and should shed the unhealthy burden as soon as possible. How much money are you saving and investing each year? If you are saving little or nothing, this also suggests you have more debt than you can safely handle. Is your cumulative debt rising, shrinking, or staying constant? If it is rising without the addition of a mortgage or similar debt with future returns, that is a bad sign. Rising debt and/or little savings suggest you may be suffering from Overspending Syndrome, a difficult but curable condition.
For more exotic forms of debt, such as consolidation debt, borrowing for leveraged investment purposes, and borrowing to start a business, we may refer you to a debt “specialist”. You can do some preliminary self-diagnosis on your debt by answering the following questions:
- What is the return you expect to receive on your debt?
- How likely is that return (realistically)?
- When should you realistically expect to see that return?
- In the meantime, are your savings dropping and/or your collective DTI growing into the higher-risk range?
We hope that your debt passed the year-end check-up with flying colors. Even if it didn’t, at least this annual checkup has no copay!