For many of us, eliminating debt is a top priority. That’s not a bad thing. But, just because too much debt is bad, does not mean that no debt is good.
The truth is, you need access to credit in order to function in our economy, so living with some debt comes with the territory. The key is to know what kinds of debt and how much you can handle, taking your short- and long-term financial needs and goals into consideration. If eliminating debt is your goal, here’s what you need to keep in mind.
How much debt is too much debt?
One Answer: You should never be using all of the credit you have access to. Your goal should be to stick as close as possible to using less than a third of your total available credit at any given time. So, if you have a total available limit on two credit cards of $15,000, you should only be using a total of $5,000. If it creeps higher—to say $7,000 in use—put away the plastic and focus on paying your balance down.
Another Red Flag: Credit card payments are eating up your income. If your monthly credit card payments begin to edge above 10% of your monthly take home pay, again, you need to let the plastic cool off to get your balances under control.
What are you borrowing the money—that is, taking on debt—for?
Always remember that, when you use a credit card, you are borrowing money and paying for the privilege with interest. It’s a bad idea to take out short-term loans to finance long-term assets. An example would be using your credit card to make your mortgage payments, especially given the likelihood that the interest rate on your credit card is much higher than the interest on your mortgage. When the credit card bill comes due, you won’t be able to use the value of your home—an illiquid asset (not easily convertible to cash)—to pay for it.
Conversely, you shouldn’t do long-term borrowing for a short-term asset. Unfortunately, we do this all the time when we use credit cards to purchase clothes and other goods that will leave you still paying down the resulting debt long after they are worn out or discarded.
My Advice: Don’t borrow, but save for purchases of short-term assets.
How much cash do you have on hand?
Unfortunately, too many of us think that credit is what you use when you run out of cash. One of the most important things you should ask yourself before taking on new debt is, “How much cash do I actually have?”
The amount of cash you can get your hands on at any point in time is called your liquidity. Peace of mind comes with knowing that if you had to suddenly pay off all of your debt at once, you can pull together the cash to do it quickly, even if you have to sell—or liquidate—some of your belongings, such as a second car or home, to do it. In fact, this is a true measure of real wealth—one that many of the athletes, entertainers, and other celebrities many of us idolize simply can’t claim, regardless of their lavish lifestyles.
The more cash and easily liquidated assets you have on hand, the more debt you can afford to take on. On the other hand, lack of liquidity can limit your options. For example, if you don’t have the cash to pay upfront fees, points, and other costs, you can’t take advantage of opportunities to refinance your mortgage at a lower interest rate.
Are you clear about financial priorities beyond eliminating debt?
You may be determined to pay down your credit card balances and otherwise focus on eliminating debt as soon as possible. That sounds like a good objective, but it could be short-sighted. For example, you should not focus on paying down debt so quickly, that you fail to fund your cash emergency funds of at least six months of your annual income, or you don’t contribute to your retirement savings each month.
It’s important that your debt management strategy is designed and executed as part of a broader financial plan that takes into account short-term, mid-term, and long-term needs and goals. This is why I urge people who want to be debt-free to sit down with a financial planner, or at least seek credit counseling.
Managing debt, much less getting rid of it entirely, cannot be done effectively without balancing your priorities and taking into account your individual circumstances, both today and into the foreseeable future. What you’ll likely find is that smart money management is less about eliminating debt and far more about learning how to use it responsibly.
Black Enterprise Executive Editor-At-Large Alfred Edmond Jr. is an award-winning business and financial journalist, media executive, entrepreneurship expert, personal growth/relationship education coach, and co-founder of Grown Zone, a multimedia initiative focused on personal growth and healthy decision-making. This blog is dedicated to his thoughts about money, entrepreneurship, leadership and mentorship. Follow him on Twitter at @AlfredEdmondJr.