As the US economy struggles along, many US consumers have been caught on the wrong side of debt. Housing debt was great when prices were inflating, the more your home was worth, the more money you had. But now that housing prices are deflating, the more debt someone has in their home, the more money they will lose – if they are selling.
Consumer debt is also a bad thing in an economic downturn because the interest rates are rising and the employment opportunities and wages are decreasing.
One Thing at a Time
The best method that I have found to reduce my debt is to pay off one thing at a time. The idea is simple and provides a goal oriented mindset to target your efforts at - a single enemy to focus on. That single goal maybe a credit card or a car loan or a mortgage or any number of things.
Ten years ago, when I graduated from college, most of my friends immediately started investing in their 401k's or Roth IRA's – rather than paying off their college loans. Investing is a great ideas, but the more your money is spread across debts and investments, the more time you have to spend managing it. Debt is also easier to rationalize or to talk yourself into living with. People feel more secure with 50k in their 401k while owning 50k in college loans, than they do if they have zero loans and zero investments. The 50k in their 401k also provides emotional support to continue to spend money, because we think to ourselves that we have lots of money in reserve – justifying the 50k in college loans as a necessary evil to secure a higher wage throughout a lifetime. I believe a much better strategy is to be realistic with yourself, paying off your loans one at a time and then pursuing your investments.
We have all heard or read a financial planner say something like, “the earlier you start investing the sooner you will be able to retire”. Although this is true, it has misled people into thinking they can continue to accumulate debt because they have started investing. What most people don’t realize is that compounded interest works the same way with investments as it does with debt. If you have 50k invested and have 50k in debt, you are not getting anywhere. Both have compounding interest rates.
Are You Actually Getting Ahead?
The real question is not “have you started investing”, but “are you actually getting ahead”. The way I like to calculate this in my budget is to look as my debt-to-income ratio. Your debt to income ratio is the percentage of your debt divided by your income per month. For example, if you owe 100k on your house, 10k on credit cards and 20k in college loans which come to a total monthly debt payment of $2000, and you have a 70k income which creates $5833 per monthly, then your debt-to-income ratio would be,
($2000 / $5833) x 100 = 34 %
The goal is to reduce this number each year. If you are reducing this number, then you are getting ahead.
Reference Article: Calculate your debt-to-income ratio
I also like to look at my total assets against my debt, which includes my investments. For example, using the above numbers for debt and say you have 100k in assets and investments, your asset-to-dept ratio would be,
100k (assets) : 100k+10+20k (debt) = 1 : 1.2
The goal here is to increase your assets and decrease your debt so that the ratio gets closer to 1:1 and than greater than 1:1. With these numbers you can answer the question of “are you actually getting ahead” and you can set goals each year to try to better these numbers.