It seems like common sense: Don’t take on more debt to pay off your bills.
Yet debt-laden consumers routinely do just that, even as they criticize the federal government for efforts to raise the debt ceiling.
The spotlight is on the government’s questionable fiscal behavior as it nears its borrowing limit of $14.3 trillion and confronts the risk of a crippling default. But most individuals are just as addicted to debt as Uncle Sam.
Total consumer debt including mortgages was $11.5 trillion at the end of the first quarter. Americans then piled more on to credit cards in April than in any month in three years.
We’ve been on a personal debt binge for a long time, in fact. The last year households carried less debt than their disposable income was 2001, according to the Bureau of Economic Analysis.
Like the government’s situation, it’s past time to attack debt more aggressively and slash spending to get it down.
“It’s time to look in the mirror and think about modeling the kind of behavior we want from our country,” says Eleanor Blayney, consumer advocate for the non-profit Certified Financial Planner Board of Standards. “Our government’s situation reflects where we are individually.”
These five essential tips for managing debt can help you avoid potential pitfalls:
1. Keep a lid on total debt.
A good benchmark for your personal debt ceiling is to limit total debt to no more than 40% of your gross income. When households have to pay more than that every month it’s generally an indicator of financial distress, according to the Federal Reserve.
The National Foundation for Credit Counseling has another way of framing it. Housing, including a mortgage, should account for no more than 30% of your take-home pay, according to spokeswoman Gail Cunningham, and all debt obligations such as credit cards and car payments should total no more than 20%.
Even if you stick to that, Cunningham cautions, you’ve spent half your income but you haven’t eaten or put gas in your car. “Stretching yourself beyond those limits isn’t going to work.”
2. Understand how your credit report can affect your life.
Having good credit in this tight economic and job environment is more important than ever, and with more far-reaching consequences.
Without it, says Blayney, it can be difficult to get hired or rent an apartment because employers and landlords now commonly look up credit reports. About six in 10 employers conduct credit checks, including 13% that do so for all job candidates, according to survey data from the Society for Human Resource Management.
Carrying a heavy debt load can have a significant impact on your credit score, not to mention squeezing you financially and leaving you more vulnerable in emergencies. But abstaining from all use of credit cards can be harmful to your score, too, and make it more difficult when you might need a loan.
3. Remember that “good debt” isn’t as good as it used to be.
Student loans and mortgages are considered good debt because borrowers generally end up making money from their investment. That can still be the case, but it’s hardly a sure thing.
Even though a college education may pay off financially in the long run, today’s graduates can end up with low-paying jobs or none at all in an environment where unemployment is 9.2%. That can make heavy student loan obligations all the more difficult to pay off, tarnishing a job-seeker’s credit report and compounding the challenge of finding work.
What’s more, home equity is shrinking as housing prices continue to fall, nudged lower by all the foreclosed homes being dumped on the market. Prices in major metro areas sank to their lowest level this spring since 2002, and the outlook elsewhere isn’t much better.
Good debt now, Cunningham says, is any debt that you can responsibly service.
4. Don’t take on credit card debt that will linger.
Part of keeping debt from mounting has to do with not just making the minimum payments. Those now-required monthly updates from your lender telling you you’re on pace to pay off your credit card in 23 years should help remind you to pay more. The average interest rate on credit cards with variable rates is 14.42%, according to Bankrate.com.
Excluding your mortgage and car payments, the target should be to have no more consumer debt than you can pay off in 12 to 18 months, says financial planner Jeff Kostis, president of JK Financial Planning in Vernon Hills, Ill.
“If you have to go beyond that, you’ve really taken on too much for your budget and your lifestyle,” he says.
5. Pay attention to fees and fine print.
Consumers who aren’t careful can end up paying a significant amount in hidden fees and other costs when they use credit.
Banks looking to make up for revenue lost when Congress tightened credit card policies in 2009 are looking to partially compensate through new or increased fees. There can be fees for phone support, foreign transaction fees, over-the-limit fees and even inactivity fees. So when using credit, make sure you understand all the fees and penalties you might be subject to.