With the right plan in place, debt has the potential to become a tool that improves your financial well-being.
Is your debt manageable? Ask yourself these questions to measure the seriousness of your debt so you can make the right plan of action for your financial situation.
In some situations, debt can be a good thing, says Neal Frankle, Certified Financial Planner and author of the financial planning blog Wealth Pilgrim. But in other cases, debt may seem unmanageable, and can keep you from paying bills and achieving long-term goals.
Understanding your debt is the first step in taking control of it. Ask yourself these three questions to help assess your debt level.
1. What Type of Debt Do You Have?
- On the left are debts like mortgage debt, which typically is mild because it usually costs less in interest, can help you reach your long-term financial goals, and can be considered an investment because the potential to profit exists when selling a home.
- On the right are debts such as credit card debt.
- In between are car debt, which is easier to avoid, and medical debt, which may be unavoidable.
2. How Much Debt Do You Have?
The size of your debt can be just as important as the type. Your debt-to-income ratio can help you determine whether the size of your debt is manageable. To calculate it, divide your total monthly debt by your gross monthly income. Although your ratio doesn’t guarantee the level of manageability you need, the Consumer Financial Protection Bureau suggests a debt-to-income ratio above 43 percent indicates you’re more likely to run into trouble making monthly payments.
But be warned your debt-to-income ratio does not take into account your monthly budget obligations, which may include child care, rent, utilities, groceries, and other necessities. Also, evaluate your budget to determine if the size of your debt payments is more than you can manage from month to month.
3. Is Your Debt Keeping You from Paying Bills and Reaching Your Goals?
Perhaps the best indicator to assess your debt is the extent to which it’s hindering your payment of regular bills such as utilities or rent. If you are sticking to your monthly budget, including loan and credit payments, consider if debt is hindering you from progress toward other financial goals, like building an emergency fund, saving for a child’s college education, or saving for retirement.
“Everybody, in my opinion, needs a financial plan,” Frankle says. “If your plan works with your existing level of debt, you’re probably doing OK, although you may be able to improve your situation. If your current plan doesn’t work, then you should put all the effort you can toward extinguishing your debt.”
If Your Debt Is Severe
If paying the minimum amount is challenging, or your debt seems unmanageable, is costing you significant interest fees, and has little to no utility, consider focusing on a strategy to eliminate credit card debt or consolidate your debt. That includes creating and following a monthly budget.
Learn more about how to get heavy debt under control, including debt consolidation loans, home equity loans, and debt management plans.
Even if your living expenses are low, and debt is your only focus, you can still start to save for an emergency fund. That’s imperative to help ensure your debt doesn’t build in the case of an unexpected emergency.
If Your Debt Seems Manageable
If your debt isn’t holding you back, work on setting some other long-term financial goals. If you’re able to manage your debt along with other bills while also saving each month, you can consider using your debt as a tool to improve your financial well-being. Here’s how:
1. Achieve your goals: Many people don’t have the means to pay cash for their own or their children’s education or a new car. By incurring a manageable amount of debt through student loans, for example, you might be able to advance your education and career — and earn more money over the long term. Or you might be able to keep your savings and investments in place if the interest earned on them is higher than the interest rate on an auto loan.
2. Build your credit score: From student loans to credit card balances, consistent, on-time payments can help build your credit score. You may need that higher score to finance a mortgage or car at a lower interest rate. “A higher score is always preferable,” Frankle says. That said, if you are carrying too much debt overall, it could impact your score negatively, so be conscientious of your total debt.
3. Earn tax benefits: If your debt consists mostly of student loans or a mortgage, you may be eligible for tax deductions. And if those deductions lead to a refund, you could use it to help pay off additional debts.
4. Improve your financial education: Learning to manage debt can empower you with the understanding of how to use debt as a tool for your situation and needs and smartly handle your finances in the long run.
No matter your level of debt, you can benefit from having a plan to manage it. “Once you know where you want to go, you’ll know what needs to be taken care of to get you there,” Frankle says.
