Helping your clients use debt wisely goes hand in hand with budget planning. While many think the term debt carries a negative connotation, not all forms of debt should be viewed with disfavor. For some, debt is a necessary piece of their financial picture, and it can be used to help obtain an education, purchase a home, or establish a business.
But what do your clients need to know about debt management to help them stay on a healthy financial path? A good place to start is with educating them on debt’s primary forms.
The Primary Forms of Debt
Unsecured debt is a liability for which the lender’s only recourse against the borrower in the event of a default is a lawsuit for breach of contract (e.g., credit card balances and student loans). Secured debt, on the other hand, is a liability for which the lender has a perfected security interest in an asset of the borrower (e.g., a home mortgage or a car loan). In the event of a default here, the lender has a legal right to repossess its interest in the asset.
It’s important to note that the distinction between unsecured and secured liabilities doesn’t lead to conclusions about when debt is appropriate. For instance, credit card balances and car loans are rarely part of a healthy financial plan because the assets acquired this way are typically fungible and subject to rapid depreciation. Avoiding these types of debt is advisable unless the client has a strict budget and the discipline to stick to it. Other types of debt, such as mortgages, student loans, and business loans, may ultimately increase net worth when used sensibly.
Debt Through the Years
Different kinds of debt might be appropriate for your clients at various stages of life.
The student years. With the high cost of college, most young adults and professionals looking to further their education will need financial aid. The options include scholarships and need-based aid for those who qualify. For many students, financial aid in the form of federal student loans is a necessary evil. Before your clients find out how much financial aid their family can access, you’ll want to educate them (and their aspiring students) on the pros and cons of federal student loans.
On the pro side, student loans offer some flexibility regarding repayment terms. In the event of adverse circumstances, the debtor may be able to defer or forebear payments. Additionally, student loans offer the potential for loan forgiveness after a period of 20 to 25 years for those in income-based repayment programs. The time frame to forgiveness can be even shorter for teachers and those who work in the nonprofit sector.
On the con side, these loans come with less-than-favorable interest rates. Plus, the government is often willing to provide more funding than needed. You and your clients must objectively analyze the need for a loan, as accepting more aid than necessary can create a liability that might not be eliminated for many years.
Further, your clients should be aware that educational loans are not dischargeable in bankruptcy—meaning it’s difficult or even impossible to eliminate a student loan during the debtor’s lifetime by any means other than repayment, loan forgiveness, or total disability.
The earning years. During this time, debt is often a means to further reasonable lifestyle goals. But unless your clients have benefited from generational wealth, they might need to incur a significant amount of debt to achieve their desired lifestyle. This liability may include student loans, car loans, and mortgages. With significant debt of these types, individuals and couples could be burdened with a negative net worth for a substantial portion of their early professional years.
While this scenario is common, your clients should be aware that it leaves them susceptible to adverse events, such as an unexpected job loss, a health crisis, or a downturn in the economy. Incurring debt beyond one’s means to pay it has represented the path to financial ruin for many.
The retirement years. Once individuals or couples are in retirement, they should have minimal need for liabilities. Typically, a mortgage would be paid off by this point, and your clients might be relying on their asset holdings to pay for living expenses and leisure pursuits. At the same time, they should keep an eye on preservation of the wealth they wish to hand down to their beneficiaries.
Assessing the Risk
With any type of loan, lenders decide what level of risk they will accept when making a lending decision. Factors they consider include credit history and the prospective borrower’s debt-to-income ratio. But the lender’s main concern is answering the question, “What is the maximum amount we can offer this borrower with the least likelihood the borrower will default on the loan?”
It’s imperative that your clients understand that a lender’s willingness to loan funds does not mean that accepting the loan is financially prudent. Instead, decisions about the need for debt should be based on each client’s budget. In addition, the generally acceptable principles for allocating a client’s resources toward specific budget items should be considered. Be sure to emphasize to your clients that a lender’s business decision to provide a loan is not necessarily aligned with generally acceptable budget principles.
Every so often, you’ll encounter clients carrying an amount of debt that exceeds what’s normal for the average household. Typically, your primary objective will be forming a plan to pay the debt down as aggressively as is reasonable. Sometimes, however, a client’s situation has become so dire that meeting the lender’s demand for minimum payments covers interest only and doesn’t decrease the principal liability. In these cases, remedial action to reduce the principal before the debt becomes unsustainable is vital, which might mean considering the options for bankruptcy.
Make Debt Management a Top Priority
Of course, there is no one-size-fits-all approach to using debt within a financial plan. But there’s a very fine line between healthy debt practices and overextending credit to an unsustainable level. So, if you’re not already talking to your clients about debt management, consider making this topic a priority.
