Getting Smart About Your Debt


Americans' recent push to eliminate
their debt is placing many families at risk. The most recent Federal Reserve
Bank of New York Quarterly Report on Household Debt and Credit shows
that Americans reduced their debt by approximately $100 billion since the
fourth quarter of 2011. However, according to Certified Financial Planner Board
of Standards, Inc. Consumer Advocate Eleanor Blayney, CFP®, Americans who
reduce debt without setting up a plan to manage it, risk their long-term
financial security.


"We tend to think about debt
far too simplistically. Witness the movement in this country from the notion
that borrowing is a good growth strategy to the conviction that all debt is bad,"
says Blayney. "Consumers need to take a more sophisticated approach to
debt, one that allows for investment while maintaining a reasonable amount of
risk that won't jeopardize a family's financial well-being. Smart debt
management can help Americans as they seek to rebuild their net worth,"
says Blayney.


Creating a debt management plan is
one of the 12 steps in CFP Board's year-long "12 for '12 Approach to
Financial Confidence." Blayney recommends consumers consider five key
points when deciding to take on debt:

The duration of assets and liabilities:
     Consumers should be hesitant to take out short-term loans to finance
     long-term assets. For example, financing a long-term asset such as a home
     with short-term loans from credit cards is an ill-advised decision. When
     payment comes due at the end of the month for your credit card, you won't
     be able to use the value from your home to pay the bill. By the same
     token, borrowing long-term for a short-term asset can spell trouble as
     well. Taking a 10-year loan for a used car that won't make it until next
     year leaves you with debt years after the car you purchased is already in
     the junkyard.

  • Your
    Sometimes it is not possible
         to perfectly match the duration of our assets and liabilities. In this
         case, take your liquidity into account when deciding to take on debt. For
         example, you might decide to refinance your mortgage at a lower rate,
         without increasing the outstanding balance. However, to take advantage of
         this strategy, you may need liquidity in the form of cash to pay the
         refinancing's upfront costs and points.

  • Interest
         rate risk:
    What happens to your debt when
         interest rates rise? If you borrowed money at a variable interest rate,
         such as a margin loan, the cost of the loan will track the increased level
         of interest rates. If, at the same time, increased interest rates
         negatively impact your asset holdings, you may experience a classic margin
         squeeze. It's important to assess the amount of interest rate risk
         exposure that is in your balance sheet. A CFP® professional can help you
         make this determination.

  • Financial
    You may be determined to get
         those credit card balances eliminated as soon as possible. However, it may
         be wiser to direct your extra cash first toward 401(k) contributions in order
         to get an employer match, or to set up an emergency fund, so you have some
         protection should unexpected expenses arise. It is a question of balancing
         your short- and longer-term priorities in a way that makes most sense for
         your individual circumstances.

  • Ratio
         of discretionary to non-discretionary expense:
    Most debt has to be serviced every month, thus becoming
         a recurring fixed, non-discretionary expense. The larger these expenses,
         as compared to other expenses that you have more control over in terms of
         their amount and when they are paid, the less planning room you have to
         react to changing circumstances. This is particularly important to
         retirees who may be living off of their investment portfolios. When the
         market takes a steep drop, the best strategy is to avoid taking money from
         investments. But if you have a large debt burden, this may not be
         possible. Taking this risk into account, it may be advisable to eliminate
         debt, even when interest rates on loans seem extremely favorable.

Source: Certified Financial Planner Board of Standards, Inc.