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Sarah Ruef-Lindquist

Sarah Ruef-Lindquist, JD, CTFA

In the Spring 2018, I wrote about Financial Wellness in general, and how good financial planning and cash-flow management can support overall health and well-being. A lot has changed in the past two years, and the topic is more relevant than ever.

Given what many are calling the most severe economic downturn since the Great Depression in the wake of the pandemic, I would like to explore what often become the most significant issues for people facing a financial crisis – and how to build resiliency to downturns – drawing on material published by our colleagues at Commonwealth Financial Network (CFN).

Debt. Generally, people carry some amount of debt: a student loan, mortgage, or car loan. It can be financially smart to make a large purchase using someone else’s money. Borrowing allows one to purchase big-ticket items with less out-of-pocket cash. And, with today’s attractive interest rates, at a relatively low cost. Taking on any amount of debt comes with risk; A financial setback can reduce your ability to repay a loan, and debt may prevent taking advantage of other financial opportunities.

How Much Debt is OK?

Take a close look at your personal finances, focusing on the following factors:

Liquidity. If there is anything many people have learned in 2020 is that it’s a good idea to maintain an emergency fund to cover three to six months’ worth of expenses. CFN warns us to guard against keeping more than 120 percent of your six-month expense estimate in low-yielding investments. And don’t let more than 5 percent of your cash reserves sit in a non-interest-bearing checking account.

Current debt.  CFN also stresses that total monthly debt payments like mortgages should not exceed 36 percent of monthly gross income. Consumer debt payments—credit card balances, automobile loans and leases, and debt related to other lifestyle purchases—they also say should total less than 10 percent of your monthly gross income. If your consumer debt ratio is 20 percent or more, avoid taking on additional debt.

Housing expenses. Monthly housing costs—including mortgage or rent, home insurance, real estate taxes, association fees, and other required expenses—shouldn’t amount to more than 31 percent of monthly gross income, according to CFN. Lenders use their own formulas to calculate how much home you can afford based on your gross monthly income, your current housing expenses, and your other long-term debt, such as auto and student loans. For a mortgage insured by the Federal Housing Administration (FHA), your housing expenses and long-term debt should not exceed 43 percent of your monthly gross income. With mortgage interest rates dropping to historic lows, many are refinancing or considering refinancing. If you are in the first few years of your existing mortgage, this can make sense, or if you would like to reduce payments to improve cash flow, this can be a great strategy. If you’re close to paying off your mortgage, however, it may not make sense given how the interest portion of payments are smallest as the mortgage reaches maturity.

Evaluating Mortgage Options. If you’re in the market for a new home, the myriad of mortgage choices can be overwhelming. Fixed or variable interest rate? Fifteen- or thirty-year term? If it were merely a question of which mortgage provided the lowest long-term costs, the answer would be simple. In reality, the best mortgage for a particular household depends on how long the homeowner plans to stay in the house, the available down payment, the predictability of cash flow, and the borrower’s tolerance for fluctuating payments.

How long will you be in that home? One rule of thumb is to choose a mortgage based on how long you plan to stay in the home. If you plan to stay 5 years or less, consider renting. If you plan to live in the house for 5 to 10 years and have a high tolerance for fluctuating payments, consider a variable-rate mortgage for a longer term, such as 30 years, to help keep the cost down. If the home is a long-term investment, choose a fixed-rate mortgage with a shorter term, such as 15 or 20 years.

Is a variable-rate mortgage worth the risk? Keep in mind that it’s generally not wise to take on a variable-rate mortgage simply because you qualify for one. With interest rates at historic lows, the direction they are likely to go is up. Although these mortgages offer the lowest interest rate, they’re also the riskiest, as the monthly payment can increase to an amount that may prove difficult to meet. Selecting a shorter loan term, such as 15 years, can help lessen this risk.

Remember, when it comes to taking on debt, the loan amount you qualify for and the amount you can comfortably afford to repay may not be one and the same. Be sure to consider your special circumstances before taking on debt to buy a home or make another major purchase.

Savings. A standard recommended savings rate is 10 percent of gross income, but your guideline should depend on your age, goals, and stage of life. For example, as retirement nears, you may need to ramp up your savings to 20 percent or 30 percent of your income. Taking full advantage of tax-deferred retirement savings and employer match programs are almost always good ideas. Direct deposits, automatic contributions to retirement accounts, and electronic transfers from checking accounts to savings accounts can help you make saving a habit.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

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