Personal Finance Lessons From U.S. Downgrade

The fastest way to lose control of your finances is to take on too much debt. While you can make some stupid investment decisions, or simply fail to contribute to your 401(k), those all pale in comparison to taking on too much debt. And the downgrade of U.S. debt shows you that anyone, even the powerful U.S. government, can get into trouble with debt.

The problem with debt is it has to be paid back, with interest. And because we can all generally borrow more than we earn, through mortgages, credit cards, car loans and student loans, if we get into too much debt, we can destroy our financial lives.

For instance, let's say you have household income of $100,000, but debts of $300,000 between the mortgage, home equity line, car loan, old student loans and credit cards. If that debt had an average interest rate of 6%, you'd be paying $18,000 a year in interest, or 18% of your household income. As the debt and interest grow, they eat up more of your disposable income and crowd out everything else you want to do, like save money for retirement.

And once the debt gets so high that it's hard to just cover the interest, everything starts to collapse. If any lender wants to be paid back the principal you owe, you don't have anywhere to go to get that money, and then you end up defaulting on everything. And once you get into real trouble, no one else will loan you money. So the game is over.

There is a debt death-spiral that can occur once you breach a certain level of debt compared to your income, and it's very hard to pull yourself out of it. In personal finance, it probably starts to happen somewhere around debt that is 3.5 to 4 times your household income. Once you're at that level, it doesn't take much to put you into a debt death-spiral. And it can happen very quickly.

If you carry lots of debt, you should be working like mad to pay it down. As you work down or eliminate debt, you gain financial freedom. And one thing people forget about paying down debt, is that as you pay it down, you're getting a guaranteed return equal to the interest payment on the debt.

• Let's say you had $10,000 of credit card debt at 15% interest. Well, it's costing you $1,500 a year in interest to carry it. If you pay it off, your return on that $10,000 is the $1,500 a year in interest you'll save, or 15%.

The entire financial crisis we're in was caused by individuals taking on too much debt. Now our government is heading down the same path, but hopefully with plenty of time to change course. Look at your own personal finances and really evaluate your debt.

While no one can tell you the exact amount that is healthy, I like to work on a ratio of total debts being no more than two times household income. So if you have household income of $100,000, you've got a reasonable handle on your debts if you don't owe more than $200,000.

Paying down debt is hard work, but it's the main way you can gain control over your finances. Once you don't owe anyone else any money, you've got lots of choices, including the ability to retire.

Bottom line. Excessive debt is the primary destroyer of personal financial security. Get your debts under control.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

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