Welcome to our second piece of a three-piece series on personal finances. In this one, we tackle debt including loans and credit cards.
Debt isn’t all bad, but like most things, there is good and bad. Owning a home for example can be a good for you and your family and may increase in value over time. Most people need a mortgage to buy a house or condo, and this can be good debt.
And then there is credit card debt. In general, you don’t want credit card debt. If you pay the entire balance each month, it’s not debt and you may get some nice rewards. However, if you don’t pay off the entire balance each month, the interest rates are often too high to manage.
Longer term items like car loans and mortgages have lower interest rates than credit cards, and you can hopefully fit these big, important payments comfortably into your “needs” bucket (see our last post on money and budget management for more). If not, you may have overbought and will need to reconsider how much car and/or home fit within your budget. Below we discuss how much to target of your earnings towards home and/or car loans as well as other expenses and investments.
So, here’s the scoop on key debt offerings you will likely experience:
- Credit cards: Credit cards are an unsecured loan. For a bank to offer you a card, they want to know you’ll pay it back. Because this "loan" is not secured against anything, if you don’t pay the amount spent by the due date, the provider will likely charge you big interest rates -- 20%-30% is not uncommon. Rule: Pay off these cards in full on time! There is no investment vehicle that can consistently payout at a higher rate than most credit cards charge in interest rates. It's one big reason why it's good to keep these paid off, so you can better manage your budget and work to build savings. See the next section in this post for strategies to pay off card debt.
- Car Loans: These are generally lower interest loans (0-5% currently) and can be a good way to fully purchase a car over 5 years. The loan is secured against your car value which allows the provider to offer lower interest rates. You will want to target paying no more than 10% of your income towards car payments. Lower is most always better! Note: the vast majority of cars and trucks are depreciating assets meaning they drop in value once you drive them off the lot and will continue lose value over the life of the vehicle. Focus on what works with your transportation and budget needs ahead of potentially overspending on a cool model and/or features.
- Mortgages: Many people want to own a home to take care of their housing needs, and this can be an investment too. That's pretty great. When you are in the market for a home, you will likely need to have 10%-20% of the house list price for a down payment, and at the same time, line-up a 30-year fixed mortgage (if you can do a 15-year or 20-year mortgage, go for it!). The amount you pay each month on your mortgage shouldn’t exceed 28% of your monthly earnings as a general rule. Current mortgage rates are 3% to 4%, which are pretty good rates historically. As your loan is secured against your house, this allows the bank to offer you these lower rates. The interest you pay can also be deducted with your federal taxes. Beware: We suggest avoiding 5- or 7-year balloons. These are mortgages with a low introductory interest rate for the first 5 to 7-year period, then the interest rate will go up significantly thereafter which can mess up your budgets or worse. You’ll also want to avoid “points” if any of the providers you are shopping are asking for these.
- Equity Line of Credit: If you own a house and either get into a financial problem or need to make a big investment and don’t have the savings, this can be a good option. You can go to your bank and get an added line of credit against your house or condo value. The interest rates are typically higher than your mortgage, but not too much higher. The interest rate will generally change with the prime or federal fund rate. So, it can go up if inflation and interest rate changes. If you use this money for a qualified home improvement, it will likely be tax deductible. When thinking about how much to budget for home improvements, some suggest not paying more than 10% to 15% of your property value for any single major improvement such as a kitchen. We’d suggest thinking about how you will pay down this equity line once you draw on it and not allowing the payment to exceed 10% of your income. Important: You will only be billed the interest on this line of credit, so you will need to figure out how much extra to pay each month to have this paid off in a time frame you think is doable (5 or 10 years is typically a good target; if you can do it sooner, all the better).
While we didn’t address student loans or home maintenance planning, we wanted to provide some general guidelines for budgeting. The US Department of Education recommends that students not take on student loans that exceed 8% to 10% of monthly income. For general home maintenance budgeting, use the 1% rule. Multiply your property value by 1% for a target budget each year. Be it appliances, flooring, or other, things will need to be repaired, replaced or maintained.
I Have Big Credit Card Debt. What Do I Do to Get Rid of It?
You may think, “This is all great, but I have major card debt, and I don’t see a way to think about any of this stuff let alone saving.” You are not alone, and for most, there is a path through, but it won’t happen overnight.
If you have big credit card debt, here are some strategies to pay it off:
- Stop using your credit cards and use cash and debit cards. The more you add to your credit card balances, the more debt and interest you will owe. Stop the bleeding and live only on the cash that you have in your checking account.
- If you have property and can get an equity line of credit, get one and payoff your credit cards! This should drop your interest rates by a large amount as well as your monthly payment. You will want to think through your plan to pay down the equity line.
- No access to a line of equity or the balances aren’t really that big? Then consolidate to a credit card that has a “no interest rate” offer for six months. This will allow you time to save up some money and a build a plan to pay down before the interest rate kicks back in.
- If you are unable to do #2 or #3 and see no path to get to 50-30-20 budget, do you have 401(k) savings? You may be able to access a 401(k) loan from your account if your company allows. If so and your job is secure, you can take a loan from your 401(k) monies of 50% of your vested balance up to the $50,000 limit. You can use this to pay off your credit card debt. This is an emergency action as this will hurt your future nest egg and has other risks; however, if you are drowning in debt, this needs to be considered.
- If none of these are options or you are not completely swimming in debt, you can take the snowball approach. Many people have debt on several credit cards. Look at the one with the smallest balance and work to pay it off. Once it’s paid off, take the amount you paid towards it and apply to the next card, and so on until you have eliminated credit card debt. These payments needs to work in your budget, so you can enjoy some life too. Some planners suggest paying off the high interest card first. That can be smart; however, it may be one with a bigger balance and harder to knock off. We’d suggest you move all or as much as allowed of this high interest card debt to a card with a lower interest rate, and then focus on the card you can pay down the fastest.
- Lastly, if there is no true way out you can find, call your card companies and bank to see if you can manage payments differently and what options they will provide. Often, something can be arranged. If the options still won’t work for you, you can consider declaring personal bankruptcy. Know this comes with many implications including when you can get access to debt again.
We hope this gives you some good ideas on how to think about debt, how much to spend on mortgages and car loans, and actions you can take to manage credit cards. If you missed our previous blog on budgeting, please give it a read. You can also learn about how much to save and how to manage competing budget needs.