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Home » Money Matters

Don't let debt cloud your financial future

Submitted by on January 3, 2006 – 9:23 pm No Comment

Credit: Vanguard.com

The United States is a nation of debtors. We love to buy things?even if we don’t have cash on hand to pay for them. There’s nothing wrong with wanting the good things in life. The problem comes when we take on too much debt?and, along with it, high interest rates and high monthly payments, which can have a harmful effect on our budgets.

One nation, under debt

The U.S. Commerce Department reported that Americans’ personal savings rate was ?0.7% in August, the second lowest on record. This meant consumers were using their savings to finance spending, including debt repayment. The report suggests that Americans are wavering under a debt burden that has made it difficult to save and invest the way they once did. In addition, the total debt burden of Americans?which includes revolving (credit card) and nonrevolving (such as fixed-term auto loans) debt?reached a staggering $2.15 trillion in August, according to the Federal Reserve Board.

Further evidence of how debt accumulation has affected Americans’ planning for their futures comes from the Employee Benefit Research Institute. Their recent survey Encouraging Workers to Save: The 2005 Retirement Confidence Survey noted that nearly 40% of workers do not participate in employment-based retirement plans. In addition, only half the workers who do participate have more than $25,000 in their plans, and 60% of workers have never tried to calculate how much they need to save for retirement.

How can you manage debt better?

It’s possible to have a healthy amount of debt as part of your overall financial picture. According to Duane Cabrera, head of Vanguard’s Personal Financial Planning Service, “Like anything, debt is OK in moderation and very appropriate for major purchases.”

A good measure of your financial health is your debt-to-income ratio, which measures how much of your monthly income goes to debt repayment. “Although opinions vary,” Mr. Cabrera said, “you should try to limit your debt to 25% to 35% of gross income.”

Not all types of debt are bad. Among “good” debt are obligations like mortgage, home equity, auto, and student loans. Mortgage and home equity loans are useful because they help you build equity in an asset?your home?that usually appreciates, and the interest on them is tax-deductible at the federal level. Bad debt consists of high-interest credit-card balances and loans to cover living expenses that exceed your income and capacity to repay them.

Controlling the types and amount of debt you incur is an important part of maintaining a healthy financial future. You should be sure that the amount of debt you carry is within your means and that you’re not stretching to make minimum payments. Much of the debt we take on subtracts directly from our bottom line for the future. If you take on too much debt today and must direct a substantial portion of your income toward paying it off, how can you set aside money for retirement and other goals?

Getting out of debt, focusing on your future

A firm resolution is the first step in the process toward reducing debt. With determination, you can ease the burden, live comfortably within your means, and save for your future.

Once you resolve to cut debt, refocus on saving and investing. Contribute more to your retirement accounts, including your 401(k) and IRA. Invest in taxable accounts too; they can help you meet your long-term goals. If you have children, contribute to their 529 plans or other college-savings vehicles. College costs represent one of the most substantial sources of debt that you may incur, so it’s smart to start setting aside money early.

Don’t tap your retirement plan

Some investors consider loans from their retirement plans?such as 401(k)s?as sources of fast cash when they need money. But beware. Taking a loan removes the borrowed amount from the financial markets, where it might otherwise continue to grow, depending on the investment performance of your holdings. Also, if you leave the employer before the loan is repaid, it will be treated as a distribution and you’ll owe income tax on it. You’ll also owe a 10% penalty tax on the distribution if you’re under age 59?. The bottom line: Don’t consider retirement plan loans an easy source of money; rather, think of them as a last resort.

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