We Asked Our Accountant: How Much Debt is Too Much?

July 21, 2012 1:07 AM

Shoe closet and credit cards

“Suicide by Economic Crisis” is a term we're hearing a lot in the news lately.  Michael Marin is suspected of committing suicide in the courtroom after being found guilty of burning down a mansion he could no longer afford. Another man who shot himself outside of Greek parliament in April is just one of many suicides attributed to the severe economic downturn in Europe.

While these situations are severe cases, they scared us into thinking about debt and debt management. Since we're getting older and accumulating more of it, we started to wonder: how much is too much? And what do you do if you've already got too much?

So, we asked our accountant – my dad, Chris Ordolis, CA – for advice. Thus begins the free use of his expert services for us all. Submit your questions here.

1. How do you avoid taking on too much debt as you accumulate assets, like home, cars, etc.?

Basically, you should:

  • look at your net after-tax income flow,
  • deduct the necessary expenses for living, such as food, shelter, clothing, medical, etc.,
  • then determine what is the balance of net income remaining to finance debt or, conversely, acquire assets that will incurr debt ( like homes, cars, etc.).

Keep in mind that it is recommended that you save 15% of net income, if at all possible, for future needs.

And there's a difference between good debt and bad debt. Incurring debt to buy a house is different than incurring debt to pay for a trip or buy a car. The debt to buy a house is offered at low interest rates, reflecting the fact that you're buying lasting value which supports/guarantees the debt. This is a good debt and the payments are mitigated by saving on rent or rental income.

The debt to take a trip is usually financed by credit card at a very high interest rate and there is no value acquired other than the personal pleasure derived from the trip. This is bad debt and should be paid as soon as possible.

The debt to buy a car is incurred for necessity and/or pleasure and  it's offered at reasonable interest rate but the asset value depreciates with time and use. If incurred, you should pay this type of debt it within the period stipulated and consider the payments as an expense in the period they're paid. Any residual value of the asset at time of disposal should be considered a bonus.

If you find that the total of your living expenses, plus debt payments, exceeds 85% of your net income then you know that you can't afford to take on any more debt.

2. What are some of the first things to do when you find yourself way in over your head in debt?

Unless you have creditors and baillifs knocking at your door trying to repossess, you may be able to take some steps to bring the situation under control.

1. First, you want to rid off high interest debt, i.e. credit cards, as soon as possible. If you have a steady job and, perhaps, some assets of value, you can try to get a personal line of credit (PLC) from your bank. A PLC is offered at prime interest rate plus 1% or 2%, which means that today you can get one for around 4% to 5%. And with a PLC you withdraw as you need to, up to the approved amount, and you pay it back as you have money available.

Use PLC money to pay debt on which the interest is higher than that of the PLC. Don't forget that interest on debts of personal nature (non-business) are paid with after tax dollars so, paying $1,000 in interest requires $1,670 gross salary for a person in the 40% tax bracket.

2. Second, try to negotiate payment terms with current creditors to stretch out the payment period, thus easing your cash flow and avoiding defaults.

3. Third, if you have any assets/items of some value, which you do not use/need, try selling them and use the proceeds to pay off debt.

4. Fourth, reduce  your personal living expenses, including necessities. Buying generic brand items comes to mind, avoiding taxis, downloading movies instead of going to the theatre, etc. Accrued savings will be surprising and can be used to pay off debt.

Once you bring your debt to a manageable level, use the suggestions outlined in question (1) to keep it there.

3. In a dire situation, is there any way to soften the blow or the embarrassment of a major downsizing in lifestyle?

Well, that depends on the lifestyle in question. If you frequent exclusive clubs and restaurants, are chauffer driven in limos, yachting the Carribbean, and skiing in Colorado, then you may be facing an embarrassing blow if you are suddenly cut off from this lifestyle. But then again, you should have known that you were living on borrowed money and should have prepared for the inevitable. Under normal circumstances though, one may introduce changes in his/her lifestyle without causing much notice and no embarrassment at all. Why be embarrassed if you didn't swindle anyone? You've  simply exceeded your financial limits and, according to advice from you financial advisor, you have to tone down your lifestyle for the next little while.

And/or you can make offer reasons to avoid spending: you're on a health kick or you have lots of work and personal projects so you can't participate in dinners or club outings or trips to the Caribbean. But you can make coffee dates, have drinks at home, go for walks. Depending on each person's particular set of circumstances, different ways can be improvised to camoufflage the impact of the downsizing. You never know, you may be the first to alleviate pressure on the rest of your social group who may be faced with similar financial strains. No one can fault you for responsible living.

I hope you found these answers provide meaningful insight into the debt problems faced by many in these turbulent financial times that may persist for a while yet.

- Chris Ordolis, CA

If you have more questions on this or other financial topics, post your questions in the comments or email them to info@empirella.com (you can totally request anonimity) and our accountant will be happy to answer them here on our site.

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