According to the Federal Reserve’s Survey of Consumer Finances,
the average American family carries $6,270 in credit card debt. This
is in addition to loans held for vehicles, homes, education and other
obligations which brings the average American personal debt to
$92,727.* While these figures may make previous generations balk, the
average cost of a car, house, and college education has skyrocketed
when compared to the average household income. While gross
household debt was only 15% of GDP in 1946, it is close to 80% now.**
As a result, typical consumers need to borrow money if they want to
buy a home, drive a car, or educate themselves or their children.
Ideally, a household should run like a business. Each year, we should
make more money then we spend, adding dollars to the left side of
our personal balance sheets while paying down debt and reducing
liabilities on the right hand side. There are several tips and tricks to
keep this balance sheet aligned, and the first is proper budgeting from
the beginning.
The first step in budgeting is to truly understand how much we spend
on a monthly basis. Fixed expenses are fairly straight forward and easy
to track, as mortgages, car payments, and student loans will typically
be the same every month. It’s our discretionary spending that needs
our full attention. A helpful exercise is to check your statements on a
monthly basis to see where your discretionary income is going and
where it can be adjusted (there are several apps to help with this).
Next, we should compare this negative cash flow to our positive cash
flows, otherwise known as our income. Are they close? If so, how can
we reduce the negative outflows, as that is usually easier than picking
up a second job and boosting income. If they are not close, that’s
great, let’s figure out how to best utilize this extra cash flow.
If you find yourself with ample cash after paying all your monthly
expenses, we should determine the best use of that cash. What short-term
or long-term goals do you have that this cash can be utilized
for? For example, if you want to save for retirement, then you should
consider tax efficient investment accounts such as your company's
401(k) or IRAs. If one of your goals is to buy a boat in the next 3 years,
then I recommend keeping this extra cash flow fairly liquid, as market
volatility can disrupt savings on a short-term basis. In either case,
setting up automatic transfers to the appropriate account is an easy
way to set this money aside to accomplish your goals.
The next step in controlling your personal balance sheet is realizing
when it is appropriate to utilize credit. As a modern consumer, you
need credit. The old adage of, "If you can't pay for it with cash, then
you can't afford to buy it" may have been sound advice 40 or even
20 years ago, but such attitudes about credit are unrealistic for most
adults living in modern times. Borrowing money for purposes of
home improvement, home purchase, education, vehicles or starting
a business are great examples of utilizing credit appropriately, as long
as the repayment on these obligations are feasible. Circling back to
our cash flow analysis above, how much leftover income do you have,
and can you afford these additional responsibilities? It’s critical not to
overextend ourselves.
Should we find ourselves a bit over extended, what is the easiest way
out? There are two primary methods of paying down debt. The first
method is referred to as the debt avalanche. This is where you make
minimum payments on all of your loans and then pay extra principal
towards your loan with the highest interest rate. This will save you
money in the long run as you pay down the highest rate first. The
second method is referred to as the debt snowball, this is where you
make minimum payments on all loans and then put extra money
towards your lowest balance. The idea here is that the morale boost
of paying off the lowest balance will push you to continue the same
disciplined repayment schedule on other obligations.
Just like a business, our personal balance sheet should have a cash
reserve readily available that is not earmarked for other goals. The
purpose of this extra savings is your emergency fund for unexpected
events. Typically, it is recommended to have 3-6 months of living
expenses stashed away. This will vary depending on your current
employment situation, whether you have proper insurance coverage,
and your stage in life. Our team would welcome the opportunity to
meet with you to discuss your financial plan. While no one has a
crystal ball, the concept of developing and sticking with a financial
plan will surely reduce anxiety and help prepare you for the future.
*https://www.bankrate.com/personal-finance/debt/average-american-debt/#:~:text=As%20of%20
November%202020%2C%20consumer,student%20loans%2C%20mortgages%20and%20more
**https://www.stlouisfed.org/~/media/files/pdfs/hfs/assets/2017/moritz_schularick_the_great_american_debt_boom.pdf?la=en
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