In today's world, the purchase of "big ticket" items requires the use of debt. It would be nearly impossible to purchase a house-particularly early in one's life-without using a mortgage. It is also extremely difficult to purchase a car without borrowing the money to do so. Many people use home equity loans to make improvements to their house or for other major purchases. And with the rising costs of higher education, many people borrow for college expenses. Utilization of debt is necessary, but it needs to be used wisely to ensure your long-term financial health.
Because most of us do not have unlimited financial resources, borrowing has a significant impact on personal cash flow. And when debt levels are not controlled, it increases the risks we take. Here are some basic, easy to calculate, tests to measure how wisely you are using debt in your life.
When looking for a new home, many focus on the number of bathrooms and bedrooms or the size of the kitchen. How do you look at the impact on your financial health? A quick and easy test is the housing costs ratio. This measures how much of your income is consumed by your mortgage, property taxes, and homeowners insurance. To calculate this amount, total the items listed for a year and divide it by your annual gross income. A healthy percentage is spending 30 percent or less on your housing costs. A measure of 40 percent or higher would indicate potential strains on your financial situation.
Use of debt rarely stops at a mortgage. College education, cars and home improvements are often acquired by borrowing money. Whether kicking tires or selecting cabinets at the home improvement store, it is also important to know the financial impact of these decisions. Total Debt Service Ratio gives a quick glance at your overall debt picture. You simply take the total housing costs mentioned above, add to it all of the other debt service payments you have, and divide it by your gross income. The target for the debt service ratio is 40 percent. A measure of 50 percent or more would indicate an unhealthy situation which should be addressed.
As you get older, your total debt should decrease. Having too much debt later in life may create an unwanted burden which may prevent you from retiring. It is a good idea to measure the total dollar value of what you owe in relation to your income. For people age 30 and younger, a debt to income ratio of 1.7 is healthy. As you age, this number should decrease. By age 45, this should be 1.0 and decrease to .5 by age 55. By age 65, this ratio should be zero.
Remember, each dollar spent on debt repayment is a dollar which cannot be spent elsewhere or saved for the future. As you consider the aesthetic attributes of your future purchase, take some time to evaluate how the borrowing will also impact your financial future.
Neal E. Watson is a certified financial planner practitioner with Fleming Watson Financial Services and a financial advisor with MIAI Inc. His office is located at 512 Third St., Marietta. He can be reached at 373-4877 and be found on the web at www.flemingwatson.com. The information contained herein is general in nature and is not intended as legal, tax or investment advice and should not be used in any actual transaction without the advice and guidance of a professional financial and/or tax advisor.