Debt Handling - What's the Right Amount of Debt?

No 'one-size-fits-all' recommendation is possible when considering the right amount of debt to assume. But that doesn't mean there are no good guidelines at all.

Naturally, credit card companies and other lenders are happy to make available as much money as they think their borrowers will repay. They take risks, but those are calculated risks. They look at default rates, current interest rates and carefully review credit history when they make loans. Borrowers can benefit by following some aspects of their strategy.

Before taking out new credit, consider the odds that you will have to default on repayment. Don't factor in to your decision the possibility of deliberately defaulting or filing bankruptcy. You'll find the consequences are rarely worth it and that should be reserved as a very last resort.

You can factor in expected increases in income - banks and other business do - but you should be very sure you're actually going to receive it. A promised raise or hoped for income from a stock sale is far from guaranteed money.

Look at current interest rates and make a prediction about where they are headed, businesses do. That's a very difficult thing to be confident about, but general trends are not random. Look at bonds, futures and other indicators. If 6% bond option prices are going down, many pros are betting interest rates will rise to above that in the future. These represent the bets of professionals about the future direction of inflation and interest rates.

Look at your own credit history the same way a bank would. Try to see it from their perspective. Would you loan yourself $10,000 at 7% for 48 months? Avoid rationalizing late payments or defaults. You may have had a legitimate reason, or you may not yet have developed the resources (inner and financial) to repay all your debts on time.

Consider your total income and expenses realistically. You may badly want a new car, but can you afford an extra $500 per month without sacrificing essentials while still meeting your current obligations? Be honest with yourself.

No one can decide for you whether it's worth assuming an ongoing $200 per month credit card payment at 12% in order to have an item you've been longing for. You may value having the item today more than you value the extra money it will cost you over what you save by saving for it.

But you should at least think about it. Impulse buying is the most common way credit card users get in over their heads, financially speaking. Project the possibility that if you wait (and saved for, say, a year) you will have both the item and something else you can purchase with the money you would have paid in interest.

Evading the fact, if it is a fact, that you can't really afford the payments is the surest way to get into financial trouble. That kind of trouble can take months or years to get out of. Think long term, be realistic, and you'll be able to decide what is the right amount of debt for you.

Consider Tax Implications In Your Debt Calculations

When analyzing financing options or debt handling issues many people neglect to include the tax implications of one strategy over another. Including tax implications in your scenarios can become very complicated. It's always handy to have a computer program that will help you. But even without that there are a few simple guidelines to keep in mind.

In the U.S., the biggest tax write-off for many individuals is the interest paid on a property loan. Since they represent large debts, paid over many years, the interest is (for several years) the overwhelming majority of the total monthly payment. As a result, much of that interest paid can offset taxable income.

But there are other tax issues involved with other forms of debt that should be factored into planning.

Taking out a home equity loan used to be primarily for the purpose of making improvements to the property. Many people these days use that money for a much wider variety of goals. A HELOC (Home Equity Line of Credit) can be used to finance just about anything - an auto purchase, repayment of credit card debt... you name it.

One advantage of this type of debt is precisely the tax benefit. Just as with a primary loan, interest on a second mortgage or a HELOC is tax deductible. So, even when the interest rate is the same as a credit card (and they are often lower), the net result can be beneficial.

The only way to know for sure in your circumstances is to do the calculations. Online loan calculators are readily available that will help you do just that. Run through several scenarios to decide the effect in your case.

It's possible to obtain a loan to pay for large medical costs. Some people pay for such things with a credit card, which is possibly the most expensive way to finance the debt. Sometimes that's necessary; no 'one-size-fits-all' recommendation is possible.

Since much of the interest on such loans, and sometimes the medical expenses themselves, is tax deductible it can be worthwhile to finance the costs that way.

Interest on or amount paid to student loans, too, is tax deductible up to a point. Your circumstances will vary from another's. Tax filing software is probably your best bet for calculating the pros and cons in your individual case. As you answer the 'interview questions' you can put in the amounts and follow the tutorial to determine the impact.

Whatever the example, whenever you are considering assuming debt - especially for large amounts - taking the time to evaluate the tax implications can save you substantial amounts of money. That can easily be worth a couple of extra hours of research, especially since you'll be able to use that knowledge time and time again.

Bankruptcy – What To Consider Before Filing

Some people think of bankruptcy as an easy way to offload a crushing debt burden, and it's sometimes the first method they reach for. Well, it may well relieve the burden, but it's far from easy and should be the very last thing you use to do so.

While the law has made it relatively easy to actually file papers, the process - like any legal proceeding - is far from painless. You will have to justify your filing, exposing all your financial history to a judge and opening it to objections by creditors. If you genuinely owe the money, they're unlikely to settle happily for 10 cents (or less) on the dollar.

Even if you're successful, there are multiple long-term impacts that you'll want to consider carefully before taking such a drastic step.

You will lose any credit cards that have outstanding balances, and others may choose to close your accounts. You'll also find it near impossible to get a home loan or other large credit line (except possibly at the kind of ruinous interest rates that probably led, in part, to your current situation).

Also, not all debts are covered even by a bankruptcy filing. Student loans, back taxes within the past three years and select other debts are generally exempt from bankruptcy protection.

That situation will persist for 10 years, during which time you will need to maintain a near perfect credit record in order to work your way back to a useful level of trust. Potential creditors will regard any bankruptcy as the most negative criterion on any credit report - even beyond a low FICO score.

Beyond the credit impact, you may actually be required to forfeit real assets - a boat, expensive jewelry and other items - depending on when they were acquired. Most states make an exception for the primary residence and your auto. If you have secondary property, that may not be protected, however.

Finally, of course, the bankruptcy procedure itself is not free. Courts always have required fees and if you use an attorney that too will cost you. That can add the final straw to an already very bad financial situation.

On the upside, you will obtain relief from debt collection efforts (provided they receive notification). Your wages can not be garnished and any foreclosure action will be stopped. By taking action sooner rather than later, you will start to build a new credit history that can be better than the past one.

Since you won't have access to new credit cards, this can actually be an advantage. There are some people who simply should not have access to easy credit, until and unless they can find a way to change their habits.

It can serve as a huge wakeup call to change any bad money management habits. For some, it's necessary to hit rock bottom before they find the inner strength to make large, positive, long-term changes.

But, hitting rocks is painful. Consider carefully before you take the plunge.