When you go to the doctor for a routine checkup, your doctor checks your vital health signs by taking your blood pressure and checking your heart rate and respiratory rate. Unfortunately, we don't have such widely available diagnostic tools to check your financial health. But that doesn't mean you can't give yourself a financial health checkup.
In our prior post, What Is Financial Health?, we provided an overview of the six vital signs of financial health. Today, we're taking a deeper dive into the fourth vital sign: debt.
Debt is something (typically money) owed to another person or entity. And Americans have a lot of it.
According to Experian's annual Consumer Debt Study, in 2018 the average American consumer had total debt of more than $94,000, including mortgages, auto loans, student loans, credit cards, and other types of debt.
While that number might seem high to some (and low to others), not all debt is "bad." In fact, certain types of debt can provide opportunities to improve your financial health. The key is knowing how to make smart decisions about if, when, and how much you borrow.
Good debt is generally something that helps you increase your net worth or save money in the long run. A few examples of good debt can be:
However, even "good debt" can have negative consequences if the interest rate is too high or if you take on more debt than you can afford to repay.
Bad debt does not increase your net worth or create future value. It includes debt you take on to purchase goods and services that don't have lasting value.
Some examples of bad debt can be:
Some debt doesn't neatly fall into either the "good" or "bad" category.
Metrics can be helpful tools for measuring how well you manage debt, your progress toward financial goals, and your overall financial health.
In Financial Health Vital Sign #1: Income, we covered the debt-to-income ratio, which measures the total amount you pay in debt payments monthly as a percentage of your monthly gross income.
Here is another debt-related metrics you might track:
Debt to-income calculates debt payment as a percentage of your gross income, but your debt service ratio measures your monthly debt and housing payments as a percentage of your disposable income.
Your disposable income is what is left over from your paycheck after taxes and other payroll deductions have been taken out. In other words, your take-home pay.
Debt service ratio = monthly debt and housing payments ÷ monthly disposable income
For example, let's say your total debt payments, including your rent, car loan, and credit cards is $1,000 per month. Your take-home pay is $6,000 per month. Your debt service ratio would be:
$1,000 ÷ $6,500 = 0.1538 or 15.38%
Your debt service ratio impacts how much of your income you can spend or save for future needs. When your debt service ratio is high, the percentage of your income you have available to save is low.
The best way to improve your debt vital sign is to avoid bad debt. Before borrowing money to buy a home or car, pay for college, or make another purchase, ask yourself how the purchase will benefit you – not just today, but in the long-term. Will the purchase provide a lasting benefit, or is it something you don't actually need and really can't afford?
Finally, shop around for a competitive interest rate and make sure you can afford to make the payments. Carrying debt without a plan to pay it off makes it difficult to pay your bills on time, cover other necessary costs of living, and save for the future.
Janet Berry-Johnson is a freelance writer and CPA with a background in accounting and income tax planning and preparation. As a regular contributor to Business Insider, Money Crashers, and several other online publications, she helps make complicated tax and personal finance information accessible to readers.
Harvest helps increase the net worth of the 99% through artificial intelligence and financial automation. To date, Harvest has refunded over $2M in bank fees and interest charges to its members with the ultimate goal of increasing the net worth of everyday Americans by $1 trillion by 2030. Our platform starts with providing immediate relief through bank fee and interest charge refunds, orients a member's financial health with our proprietary PRO Index™, and keeps track of net worth over time aided by our suite of financial tools. Check out our 8-step guide on "How to Build Wealth from Nothing" to get started on increasing your net worth.
Disclaimer: Harvest is not providing financial advice. The content presented does not reflect the view of the Issuing Banks and is presented for general education and informational purposes only. Please consult with a qualified professional for financial advice.