25 02 2013
My amount of Debt is Fine, Right?
Not sure whether the amount of debt that you carry is ok? Chances are that if you have to ask, you’re over your acceptable tolerances. Before you can decide whether your debt is too high, you have to consider that there are different types of debt: constructive and destructive.
As the name implies, constructive debt is “good” debt that is being used to build wealth. This includes home loans, loans for investments and businesses, and leveraging accounts from your stock brokerage. Destructive debt is financing used to purchase depreciating assets, like cars, boats, and the like.
Now consider the type of debt that you have. Does your debt consist mostly of credit card debt used to buy things like clothes, food, and vacations? Do you have a high car note? Or is your debt primarily from investing in things like real estate?
Beyond identifying your type of debt, you should consider the amount of time it would take to pay off your current debt at your current pay. If you can afford to pay your destructive debt within the span of two years, you are probably fine. However, if it would take more than two years to repay your destructive debt, you should review your finances and consider ways to reduce your debt. Determine whether you are able to reduce the interest you pay for your vehicle by paying down the principal before payments are due. You may also want to consider a debt consolidation loan or credit counseling program.
Those of you who have a great deal of constructive debt should also take care to not become over-extended. Purchasing stock by leveraging can cause serious problems if you cannot afford to cover the amount that the brokerage lends you to purchase securities. The same goes for real estate investors who buy much more than they can afford to cover, in the event that they experience high vacancy in rental units. Problems can also occur if repair costs are higher than estimated, and the investor cannot afford to complete renovations. To determine whether you are overextended when it comes to constructive debt, calculate the amount of monthly payments you would be able to afford if 20% of your rental property is vacant, and 20% of the systems in your property must be replaced. This should give you a rough number, above which you should VERY carefully venture.