Posted: July 31, 2012
Seven essential financial questions: No. 5
How much debt do you have, and when can you pay it off?By Michael Hood
There is no more controversial financial planning topic than the use of debt. I recommend the reasonable use of debt for buying a home; beyond that I recommend avoiding debt whenever possible. The main drawback to debt is the disastrous impact it can have on the lives of families who have too much of it.
The pain that comes with the loss of a job is compounded if there are big credit card bills and car payments. There is no question that debt and stress are closely linked. The debt to avoid is consumer debt—typically credit cards, car loans and home equity lines of credit used for consumer purchases.
If you currently experience the stress of accumulated debt, understand you are normal, and there is a solution. The solution will take time and require some personal discipline, but there is no more rewarding feeling than getting yourself and your family out of debt.
The method of attack that I have found to work best is the approach taught by Dave Ramsey called “the debt snowball.” The basic idea is simple. First, list your debt balances, smallest to largest. Continue to make the minimum payments on all of your debts except the smallest. Pay off that smallest debt as quickly as you can. Once that balance is paid off, move to the next one on the list. This process allows you to make real progress and celebrate each small victory on the path to winning the debt war. With no credit card bills or car payments there will be extra money available in your monthly budget to go to saving for short-term projects and your long-term goals.
The use of debt in the form of a mortgage to purchase a home is a necessity for most people. But, like any debt, if the borrowed amount is too large to easily pay for each month, then the dream home can become a nightmare. I recommend using the guidelines that were common a few decades ago: Put at least 20 percent down and use a fixed-rate mortgage that makes your monthly payment less than 25 percent of your take-home pay. This may seem conservative—and it is—but these mortgage guidelines have historically helped keep people out of financial trouble.
The main goal is to get your mortgage paid off before retirement. I encourage my clients to be done with their mortgage ten years prior to retirement. This allows for much larger savings in the final decade of working. Debt can be a helpful tool or it can be a detriment to achieving your financial goals. Whenever possible, avoid the use of debt.
Michael Hood, CIMA®, is a Certified Financial Planner™ and First Vice President of Wealth Management for Morgan Stanley Smith Barney in Denver. He can be reached at 303-925-9648 or firstname.lastname@example.org. Visit his website at http://fa.smithbarney.com/hood.