Debt breakdown: Is being-debt free a realistic goal?
We help you understand your debt profile in order to evaluate what balances are realistic and how to best manage large purchases like homes and college educations.
Few of us are debt-free. Depending on how much debt you have, it can loom over your life like a dark cloud. Many financial experts tout being debt-free as a surefire way to financial success but often this bit of advice is too idealistic. Our financial profile is largely based on our credit score, which is solely based on our debt profile. Being debt-free may not be realistic for many and, in many cases, it can actually hurt your financial well-being.
Be mostly debt-free with your credit cards
Not all debt is bad debt. Lenders are interested in your ability to repay — those with higher credit scores are more reliable in terms of the amount of debt they carry and the consistency with which they make repayments. Credit card debt is really the thorn in your side. Take a look at the ratio of your balance-to-limit ratio: This is the amount of debt you carry on a card divided by your total limit. Aim for 7 percent or lower combined and never more than 30 percent on a single card.
For example, let's look at a fictional case:
- Card 1: Balance of $2,000 with $10,000 limit = 20 percent balance-to-limit ratio
- Card 2: Balance of $1,000 with $5,000 limit = 20 percent balance to limit ratio
- Card 3: Balance of $500 with $3,000 limit= 16 percent balance-to-limit ratio
- Total: Balance of $3,500 with $18,000 limit = 19 percent balance-to-limit ratio
This individual's large amount of credit card debt is hurting their score. He or she would want to get their total number from 19 percent to 7 percent and focus on bringing all three cards down to a maximum of $1,300 in combined outstanding balances.
When your total balance-to-limit ratio is at 7 percent, as you further reduce your credit card debt you'll see a smaller gain in your credit score. You may feel great with zero credit card debt, but your credit score isn't going to see as big of an increase in points. Lenders want to see that you use credit but do so responsibly.
Big ones: student loans and mortgages
Student loan and mortgages are major investments in your future and carry large sticker prices. Many people can't imagine paying off their home decades earlier than the maturity date of their loan (although some people do). What's important with these items is to play it safe. Make sure you take out loans with payment schedules you can afford even if your financial situation were to drastically change. Debt isn't bad but being overloaded with debt is — don't hope for the best, plan for the worst.
Being debt-free should be an ongoing process. Be sure to eliminate your credit card debt to about 7 percent and make sure you focus on easy student loan and mortgage payments. Debt is a tool that allows you to build your financial profile for future lending. When used correctly, you'll find even if you aren't debt free you are still financially sound.