Earning capacity and money management skills don't always go hand-in-hand. If you're a high earner with high levels of debt, you aren't alone, but there are key steps you should be taking to get on the path to financial independence. Once you understand your comprehensive financial picture, the difference between high income and having true wealth, and your options for getting out of debt, you'll be on the path to financial security.
How High Income and High Debt Are Related
Many people associate a high salary with financial security. The truth isn't that simple. Many of the highest earners enter their working years with high amounts of debt and as you might expect, if you begin your career in debt, it will take you longer to get to the point you're able to build wealth. In addition, if you spend more than you earn, your debt will continue to grow and attach and anchor to your financial trajectory.
People who have high incomes often have high debt levels due to the following factors:
- Student loan debt. Many well-paying jobs require some level of higher education. School tuition, particularly graduate school, can be astonishingly expensive, and it is not unusual for those entering the workforce in high-earning careers to have a significant amount of student loan debt.
- Greater access to credit. Credit card companies and bank lenders are more likely to extend loans and credit if you have a higher income or even expect to in the future. Unchecked, this approval with high credit limits makes it easier to get into debt.
- Lifestyle creep. There's often pressure to show off your success through overspending luxury on status goods on cars, electronics, clothing, and travel. Similarly, if you associate with people who live in high style, you may spend more than you intend on travel, entertainment, and other luxuries.
- Higher cost of living. Higher incomes tend to concentrate around urban areas. If you live in a major city, your high salary may be offset by a high cost of living, preventing you from being able to pay down existing debt or save to prevent it in the future.
The Impact of High Debt
- Credit score damage. Your credit score is based on several factors, including your debt load. If you carry a high balance on your credit cards, your score may suffer.
- High debt-to-income ratio. Lenders that issue mortgages and auto loans also consider your debt-to-income (DTI) or debt-to-equity ratio when deciding your creditworthiness. A high debt level often leads to less-than-favorable loan terms. This means higher interest rates, additional fees, or shorter loan periods with higher monthly payments.
- Fewer options: Generally when your debt level is already high, your ability to borrow or access credit is compromised, which can limit your options. If you unexpectedly lose a source of income, come across a business opportunity, or face emergency expenses, such as a medical bill or a home repair, you may have difficulty securing the cash or credit you need.
- Further indebtedness: Less favorable credit and loan terms means higher interest rates, more fees, and larger monthly payments. These factors increase the amount of money you owe.
While your career success provides you with an enviable income, it also increases your risk of getting into high levels of debt. Being aware of this risk is critical to avoiding short-term financial strain as well as enabling you to start building wealth for the future early.
How High Earners Can Avoid Debt
Income is the money you're regularly bringing in (likely from a job). Your wealth is the value of your assets minus your debt load. Avoiding and paying off debt are essential steps in building wealth, especially early on. Fortunately, high income offers a significant level of flexibility when it comes to managing your finances.
Understanding Your Financial Obligations
The first step in getting out of debt is understanding your financial obligations. These include living expenses along with any debts. Everyone's situation is different, but here are some typical expenses to consider:
- Rent or mortgage payments
- Taxes
- Utility payments, including heat, water, electricity, trash removal, cable, and internet
- Car payments, maintenance, and fuel
- Insurance policies
- Medical bills
- Groceries and household items
- Credit card debt payments
- Student loan payments
- Child care
- Child or spousal support payments
- Pet care
- Clothing
- Health and wellness expenses
Review your bank and credit card statements to learn how you spend your money. You might be surprised at the number of obligations you have and what they cost you each month. You don't have to start from scratch, though. Many banks and credit companies now offer easy-to-use solutions through an app or their website to help you bucket and track your expenses with minimal upfront effort. You'll be surprised how much some of the small things add up and how seeing your expenses in the aggregate can encourage better spending habits.
Creating a Budget
Now that you know your obligations, create a budget that you can stick to. This last bit, "that you can stick to," is essential. It's easy to have noble intentions when creating a debt reduction plan but following that plan is a greater challenge. A solid budget helps you pay debts, keep up with your expenses and enjoy a reasonable standard of living while providing a financial cushion that allows you to handle unexpected expenses. It can be a trap to set too strict a budget that you abandon quickly.
Strategies for budget creation:
- As mentioned above, begin by tracking all of your expenses and understand where you're spending.
- Next, calculate your monthly income. This should include income from your job, your spouse's job, and other regular sources of funds, including side gigs.
- Once you understand your income and spending, consider how much money you have left over at the end of each month. These funds can be added to savings or an investment account.
- If you are spending more than you earn, or you aren't able to make payments on existing debt that exceeds the minimum, it's time to cut back. Ideally you'll be paying more than the minimum and able to contribute to savings or investments. Identify areas where you are overspending and take concrete steps to reduce expenses and manage existing debt.
Start Managing Debt
Once you've set your budget, commit to using surplus funds to pay your debt. There are several approaches to doing this, and two of the most popular are the debt snowball and the debt avalanche:
- With a debt snowball, you list your debts according to balance, starting with the lowest first. After making minimum payments on your debts, apply leftover funds toward your smallest debt. Once that debt is paid, you tackle the debt with the next lowest balance. As you eliminate each debt and its monthly payment, you have more money to bring down the balances of your larger debts.
- A debt avalanche is similar to a debt snowball, except that you order your debts according to their interest rates, prioritizing making higher payments toward the debt with the highest interest. The advantage of the debt avalanche is that you will spend less on reducing your debt. The disadvantage is that it doesn't offer the motivation of "wiping out" debts quickly the way the snowball approach does.
Another option is to reduce the interest rates of your unsecured debts by consolidating what you owe at a lower interest rate. This form of debt relief isn't always available to everyone and depends on your credit history. However, if you've been able to maintain a good credit score and can secure favorable credit or loan terms, your options include the following:
- Taking out a debt consolidation loan or personal loan through a bank or credit union and paying off your debts in one lump sum.
- If you own a home, consider a home equity loan. Since this is a secured loan, you may easily get approval. There is, however, the risk of foreclosure if you cannot make your loan payments. If you're considering this option, you might want to chat with both your home loan provider and a financial advisor.
- Seek out a balance transfer credit card. These credit cards have a very low introductory interest rate. Some may even offer an initial interest rate of zero. Transfer your balances to the card and pay off as agreed to avoid high interest rates.
However, remember that a debt management plan involving taking out a loan (or opening another credit card account) can be risky. You might create an even deeper debt if you don't change your spending habits. This can further impact your credit score and damage your financial health. Be prepared to stick to your plan.
Add to Your Savings Account
Your budget should include regular contributions to a savings account. While savings accounts don't provide the financial returns that some financial products do, they provide easy access to funds when needed, with no or minimal financial penalties for having a low balance.
Having a standard bank account also reduces the chances that you'll go back into debt when faced with a financial emergency, as you'll have the funds to cover these unexpected expenses. Sometimes, a relationship with a bank may also increase your loan eligibility at favorable terms. Once your savings reach a certain level, it may be time to transfer some funds to an investment account.
Work with a Financial Advisor
If your financial situation is mixed: You have a high income and high debt, but the debt is currently manageable, working with a financial advisor might be a wise strategy. Your financial advisor can provide a realistic assessment of your financial circumstances and a plan for eliminating debt, reducing tax liabilities, and maximizing investment options. They'll also help answer specifics on the order and amount in which you should be paying off debt, contributing to savings, and starting investments. It can be hard to know what to do to align with your long-term plans.
Nobody wants to struggle with debt, but everyone can agree your worst option is to ignore it. If you are earning enough to get your debt under control and haven't been able to do so, consider the tips above to help manage on your own or look into professional support. If you're looking for some high-level recommendations, check out our free financial analysis. It can point you toward areas within your financial plan, including debt minimization, to focus your efforts on.
