Are There Good Liabilities?

If you read yesterday’s post, you will know that I recommend an annual financial checkup to help you determine your current financial health. Let’s face it. It’s almost as important as your annual physical checkup. Not quite, but almost. When you list your assets, with the exception of your house, and tally up your liabilities, you get a quick idea of your financial help.

Now you need to take a look at your liabilities. Is there such a thing as a good liability? In an ideal world, the trick would be to have no debt. Imagine how much less it would cost to live if you didn’t owe anyone any money. However, we do not live in an ideal world and most of us can not afford to pay cash for our houses, so we are forced to take on debt in order to have a place to live.

So for the purpose of our annual checkup, I am going to say that mortgage debt is ok as long as the monthly payment does not exceed 25% of your wages. Another guideline is that the total cost of your house should not exceed 2.5 times your annual wages. In some parts of the country, it would be impossible to find a house that meets that requirement for most of the population, but it is a good guideline nonetheless.

So if mortgage debt is a good liability, what constitutes a bad or risky liability? Number one on the bad list would be credit card debt as I’m sure most of you already know. There are several things about credit card debt that make it dangerous to your financial health. First, the ease of use makes them dangerous. It is just too darn easy to spend money we don’t have with our credit cards. Combine the ease of use with our consumerist society full of commercials telling us what we need to be happy, along with banks competing for our credit card business by offering us low rates and high limits and we have a recipe for disaster.

The low monthly minimum payment lures us into false sense of comfort. We figure that as long as we can make that small monthly payment, we are ok. The problem is that if we only make the small monthly payment it will take us 15 to 20 years to pay off our credit card balance if we ever pay it off.

Hit your credit limit? No problem, just give the bank a call and they will increase your limit. After all, the more you owe, the higher your payment, and the longer it will take you to pay off the balance. For the bank, it’s like owning a cash cow that never quits giving.

Another danger of credit card debt is the bank's terms and conditions. If for whatever reason, you are late or miss a payment, the bank can raise the interest rate on the balance of your card without notice. That annual rate can be 20 to 30%. Not only can they raise the interest if you miss a payment to them, they can raise interest if you miss a mortgage payment. When you miss a mortgage payment, the mortgage company notifies the credit-reporting agency and from there it goes to your bank.

Now there is a new danger on the horizon for folks with high credit card balances. The banks who issue cards count credit card debt as an asset and a bank with large assets has more money to lend and more money lent to people like you and I means more interest income for the bank and growing assets. Recently the banks lobbied to get a bill passed that would give the banks who issue credit cards more protection from individuals who run up big credit card balances and then declare bankruptcy. The law was signed into effect by President Bush and becomes effective in October.

What most people do not know about this law is some of the guidelines regarding payback periods that the banks must follow when issuing and collecting on their credit cards. Let’s say you owe $10,000 on your credit card. (By the way, that happens to be close to the national average for individual credit card balances.)

Depending on the credit card company, if you only make the minimum monthly payment on that card and never charge another dime, it will take you between 15 and 20 years to pay it off. Effective in October, the minimum payment schedule must be structured in such a way that the balance is paid off in no more that 10 years. That means that for millions of Americans who have maxed out their credit cards and are just able make their monthly minimums, those minimums will double come November.

Trust me, you do not want to be in that position when November rolls around. Have you read about this in any of the newspapers or heard about it on television or radio? No, probably not, but it’s coming and things will get tough for a lot of folks.

Next week we look at the next part of our financial check up. Your personal income statement.