Debt and the American Dream

It’s almost impossible to live in America without incurring some debt. Unless you were lucky to have been born with a silver spoon in your mouth, you’ll need to borrow money for big ticket items, such a purchasing a home or paying for college. But for some Americans, their balance sheet is not so balanced. That’s because their personal debt is rising faster than their income.

According to the Federal Reserve, at the end of 2014, Americans had a total of $882 billion in credit card debt. That total was up 3.3% from the previous year, despite the fact that the average American’s income grew by only 1.7% during that same time frame.

The average American household had over $15,000 of credit card debt, $155,000 of mortgage debt, and $32,000 of student debt. Americans living in large cities, such as Los Angeles, San Francisco and New York, typically owe significantly more on their mortgages. Americans with graduate and professional degrees are likely to carry even higher student loan debt.

What do you need to know about debt in relation to your financial plan? Here are 2 principles to remember:

1. You Can’t Build Credit without Going into Debt

It’s a classic Catch-22. In order to build good credit to get a home mortgage, a car loan, or a credit card for airline miles or emergencies, you have to incur debt. Financial institutions want to see that you have a track record of paying off your debts before extending you additional credit. See what I mean? A real Catch-22!

But with our consumer driven economy and easy access to credit cards, many Americans end up with more debt than they can afford to pay or have a high debt-to-credit ratio. Ideally, your total debt service, including credit cards, auto loans and other consumer debt, should account for no more than 36% of your gross monthly income. If you are looking to buy a house, for example, this is a key factor in determining your overall creditworthiness.

2. Not All Debt Is Created Equal

Since you need debt to build your credit file, keep in mind that not all debt is bad. There’s such a thing as good debt and bad debt. For example, mortgages are not generally considered to be bad debt, as long as you don’t borrow more than you can afford to pay.

Credit card debt, on the other hand, can be the worst debt. Credit cards tend to have higher interest rates than school loans, auto loans, and mortgages, costing you more money in the long run. For that reason, someone with $400,000 of mortgage debt and no credit card debt may have a better credit score than someone with $10,000 of credit card debt, but no mortgage.

Managing and paying down “bad debt” is not only essential to your overall financial health, but also to your personal well-being, since a high debt ratio is generally closely associated with increased levels of stress. If your debt is out of control and/or you simply want to improve your overall creditworthiness, a financial planner can help you out of the debt maze and get you back on track.