Got Debt? These Five Steps May Get Your Finances on the Right Track

Quick Take:

If you've got yourself in a financial hole, it's time to stop digging.

Americans borrowed a mountain of money this decade, as they rushed to buy properties during the real-estate boom and as they sought to maintain lifestyles they couldn't really afford.

Worried you have too much debt? Here's how to gauge whether you have a problem, how to get yourself back on track and how to keep future problems at bay.

Reading the signs. To figure out if you're in the danger zone, consider the guidelines used by mortgage lenders. As a rule, mortgage lenders don't want your monthly mortgage payment-including principal, interest, property taxes and homeowner's insurance-to amount to more than 28% of your monthly pretax income.

Meanwhile, they prefer to see total monthly debt payments at no more than 36% of pretax income. These total debt payments include not only your mortgage, but also amounts owed each month on auto loans, student loans and other debts.

While such numbers are useful benchmarks, don't take them as hard-and-fast rules. For instance, in major cities on the East and West coast, with their lofty home prices, you will likely find it tough to keep your monthly mortgage payment to just 28% of pretax income, especially if you're a first-time home buyer.

Getting good. If you have a mortgage, forking over the full 36% of your pretax income for all monthly debt payments isn't necessarily worrisome. What if you're paying that much-and you don't have a mortgage? It is time to start worrying.

Folks often talk about good debt and bad debt. A mortgage would be considered good debt. After all, mortgage rates are usually low, the interest should be tax-deductible and the money is being used to purchase an asset that should provide your family with both a place to live and some modest home-price appreciation.

Similarly, education loans would be considered good debt. Your education loans may charge you a higher interest rate than your mortgage and you may not be able to deduct the interest you incur. Still, your time at college is likely setting you up to earn a higher income, so the payback could be impressive.

Auto loans aren't necessarily bad debt. But they aren't particularly good, either. You can't deduct your interest expense. Your car will slowly lose value. Nonetheless, for many people, taking out an auto loan is the only way they can afford to buy a car-and that car is, for many, pretty much a necessity. Finally, watch out for credit card debt. The interest rate levied can be high and you can't take tax deduction for the financing charges. While credit cards are often helpful in managing your monthly expenses, try not to carry a very large balance on a regular basis.

Shedding debt. What if you have amassed a lot of debt, especially bad debt? Folks are sometimes tempted to let things continue to slide, figuring the damage has already been done.

Resist that impulse. If you feel your finances are spinning out of control, the first step is to stop accumulating debt and put yourself on a cash diet. As soon as you get your paycheck, make your required debt payments-and then force yourself to live on whatever remains.

Next, figure out which debts you should aim to pay off first. In all likelihood, you will want to rid yourself of your highest-cost debt, which will typically be your credit-card debt.

But if there's little wiggle room in your finances, you might see if you can buy yourself some breathing room by quickly reducing your required monthly debt payments. That may mean paying down lower-cost debts first.

To understand the issue here, suppose you have both a heap of credit-card debt that is costing you 14% and also an auto loan with an 8% rate and a $400 required monthly payment. Yes, the credit-card debt is costing you more. But if the auto loan has just a year to run, you might kill it off quickly by making some extra payments, thus reducing some of the pressure on your finances.

Considering consolidating. You might also buy yourself some breathing room, and simultaneously simplify your finances, by consolidating your debts. This works best if you own your home and have built up some home equity.

You can borrow against your home through a home-equity loan or line of credit and then use the money to pay off higher-interest debt. As an added bonus, the interest on your home-equity borrowing should be tax-deductible.

Alternatively, you might pay off other debts by refinancing your home and taking out a larger mortgage. This makes most sense if you can, in the process, also lower your mortgage rate.

But again, imagine you have little financial breathing room. Even if you can't lower your mortgage rate by refinancing and even if you can't borrow more money, you may be able to reduce your monthly mortgage payment simply by taking your current 30-year mortgage-which might have, say, 24 years left to run-and refinancing the loan back over 30 years.

This will mean incurring mortgage-application fees and other costs. Still, that may be the price you have to pay to get your finances back on track.

Avoiding a relapse. Once you have dug yourself out of debt, you'll want to make sure you don't slip back. The surest method is to use cash or a debit card to pay for all purchases.

Many people, however, favor credit cards, so they can earn cash back, frequent-flier miles and other rewards. If you use credit cards, try deducting your credit-card charges from your check register. That way, you know you will have the money to pay off the credit-card bills when they arrive.

You might also keep a cash cushion in a high-yield savings account. The money should earn a decent amount of interest. More important, you'll have yourself a financial backstop if there's a month with a lot of unexpected expenses and you can't pay off your credit-card balances with your checking account.

Such strategies will stop renewed bleeding. But what you really want is to start making some financial progress. One possibility: Turn your debt payments into regular monthly investments.

Let's say you are paying $350 a month on an auto loan. When the loan is paid off, keep writing that check every month-but send it to your appropriate mutual fund instead. You are used to living without the $350 every month, so this should be a painless way of stepping up your savings rate. Be warned: A periodic investment plan, such as dollar-cost averaging, does not assure a profit or protect against a loss.

While paying down debts should give you some sense of financial control, you probably won't find it as satisfying as starting to save money for your future. For that reason, consider coupling a debt-reduction program with a savings program, preferably through your 401(k).

This is also financially smart. There are few investments that can match the effective return from paying off high-interest debt. But funding a 401(k) with an employer match is the one investment that's maybe more attractive.

Source: Jonathan Clements, Director of Financial Guidance, Citi Personal Wealth Management.

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