One of the things we learned following the housing bubble and economic recession was that too many Americans had their net worth tied up in their home values. Back when getting credit was easy, many people qualified for home loans they couldn’t really afford and then took out home equity loans to finance their lifestyle.
In fact, from 2007 to 2010, the median American household lost 47 percent of its wealth, according to the National Bureau of Economic Research. This was largely due to the high leverage of middle class families and high share of homes in their portfolio. For most of middle America, housing represents about 67 percent of their total wealth, according to a 2012 study by the National Bureau of Economic Research. Obviously, with this much wealth concentrated in home equity, when housing values fall, so does your net worth. To make matters worse, many people lost their jobs and had to resort to using credit cards and loans to supplement their household income – driving them further into debt.
One important lesson to learn from the first decade of the millennium is that credit is a financial tool that should not be used precipitously. When it comes to your own personal balance sheet, managing what you owe is just as important as managing what you own. Choosing the right lending program is as much a part of the financial planning equation as saving and investing. Decisions such as whether to refinance, buy a new home and what type of mortgage to select are part of the overall planning process.
When you need cash, sometimes it’s better to borrow against your own collateral rather than from a third-party lender. For example, while you can take out a home equity loan or line of credit against the equity you have in your home, you can also borrow money using your investment portfolio as collateral with a securities-based line of credit or margin account. This however, can be risky, as it puts your personal assets at risk.
During the recent economic decline, many people borrowed from their 401(k) retirement plans at work to help ends meet. One in four American workers with a 401(k) or other defined contribution plan tapped retirement accounts to pay their mortgages, credit card debt or other bills. One-third of people in their 40s have tapped these accounts for current expenses, according to Hellowallet.com.
Between low property values and high debt from equity loans, 401(k) loans, and credit card balances – not to mention poor job prospects and a high unemployment rate – many Americans are trapped in their current financial situation.
But there are positive signs that the economy is turning around – especially the real estate market. Once people pull themselves out of debt and re-establish themselves on firmer financial footing, it’s important to take the lessons they learned from the “lost decade” of the new millennium and position their finances to ensure high debt doesn’t trip them up again.
That doesn’t mean you shouldn’t use credit. On the contrary, building and maintaining your credit score is the foundation for good financial money management. If you don’t take on debt and establish a strong track record of paying it back, your credit score will suffer and you’ll miss out on the best interest rates on mortgages and other loans.
However, there’s a balance that should be maintained, and it’s usually achieved through discipline. If you save and invest regularly – automatically – you can build your net worth over time to help secure your financial future. But for current expenses, it’s a good idea to save for short-term goals. You can always pay for these items on credit and then pay them off promptly to enhance your credit score.