You Should Set Your Own Debt Limit
You, rather than a lender, should set your own debt limit, which is the overall maximum you believe you should owe based on your ability to meet the repayment obligations. Most people’s debt limit is, and should be, lower than what lenders are willing to tender. Lenders are willing to take chances that some borrowers will not repay. By contrast, you should not take such a chance when making your own credit decisions
When considering a new loan, many people simply look at the monthly payment required. This view is shortsighted as it is easy to get a low monthly payment simply by lengthening the time period over which the loan will be repaid. You should assess your overall debt obligations. There are three ways to determine your debt limit:
1. Debt payments-to-disposable income method
2. Ratio of debt-to-equity method
3. Continuous-debt method
Debt Payments-to-Disposable Income Method
To use the debt payments-to-disposable income method, you first need to decide the percentage of your disposable personal income that can be spent for regular debt repayments, excluding the first mortgage loan on a home and credit card charges that are paid in full each month. Disposable income is the amount of your income remaining after taxes and withholding for such purposes as insurance and union dues. Table 6.1 shows some monthly debt-payment limits expressed as a percentage of disposable personal income. As the table indicates, with monthly payments representing 16 to 20 percent of monthly disposable personal income, a borrower is seriously overindebted and fully extended; taking on additional debt would be unwise. This means that someone with an average income and an expensive car loan might not be able to afford to carry any credit card balances that carry over from month to month
You, rather than a lender, should set your own debt limit, which is the overall maximum you believe you should owe based on your ability to meet the repayment obligations. Most people’s debt limit is, and should be, lower than what lenders are willing to tender. Lenders are willing to take chances that some borrowers will not repay. By contrast, you should not take such a chance when making your own credit decisions
When considering a new loan, many people simply look at the monthly payment required. This view is shortsighted as it is easy to get a low monthly payment simply by lengthening the time period over which the loan will be repaid. You should assess your overall debt obligations. There are three ways to determine your debt limit:
1. Debt payments-to-disposable income method
2. Ratio of debt-to-equity method
3. Continuous-debt method
Debt Payments-to-Disposable Income Method
To use the debt payments-to-disposable income method, you first need to decide the percentage of your disposable personal income that can be spent for regular debt repayments, excluding the first mortgage loan on a home and credit card charges that are paid in full each month. Disposable income is the amount of your income remaining after taxes and withholding for such purposes as insurance and union dues. Table 6.1 shows some monthly debt-payment limits expressed as a percentage of disposable personal income. As the table indicates, with monthly payments representing 16 to 20 percent of monthly disposable personal income, a borrower is seriously overindebted and fully extended; taking on additional debt would be unwise. This means that someone with an average income and an expensive car loan might not be able to afford to carry any credit card balances that carry over from month to month
Table 6.2 shows the effects on a budget of increasing debts. In the table, after deductions, disposable personal income amounts to $2200 per month. Current budgeted expenses (totaling the full $2200) are allocated in a sample distribution throughout the various categories. As you can see, increasing debt payments from $0 to $550 per month (for example, to buy a new automobile or home entertainment system on credit) has dramatic effects on this budget. A responsible financial manager must decide where to cut back to meet monthly credit repayments. As the debt load grows, each 5 percentage point increase makes it much more difficult to “find the money” and make the cutbacks. In this case, the borrower reduced expenditures on savings and investments immediately and then finally reduced the amount in this category to $50. Food was cut back, but only slightly. Utilities, automobile insurance, and rent are relatively fixed expenses; as a consequence, it is difficult to reduce these amounts without moving or buying a less expensive car. Entertainment expenses were steadily reduced, and newspapers and magazines were eliminated altogether
Where would you make reductions? Spending a few minutes changing the figures in Table 6.2 will give you an idea of your priorities and the size of the debt limit that you might establish. Note that the debt payments-to-disposable income method focuses on the amount of monthly debt repayment not the total debt. As a result, it also would be wise to consider the length of time that the severe financial situation caused by high debt payments might last. It could be years, many years.
Ratio of Debt-to-Equity Method
Another method for determining your debt limit involves calculating the ratio of your consumer debt to your assets. The debt-to-equity ratio is similar except that it uses the equity in a person’s assets (the amount by which the value of those assets exceeds debts), excluding the value of a primary residence and the first mortgage on that home. This ratio recognizes that mortgage debt does not get people into trouble. In fact, mortgage debt is backed up by excellent collateral—one’s own home.
From Table 3.3 on page 69, we see that the Hernandez family has assets of $133,920 ($4420 monetary assets; $20,500 tangible assets less the value of their home; and $109,000 investment assets). Their debts (excluding their home mortgage) total $9365 ($120 $1545 $7700). With $9365 in debts and $133,920 in assets, the Hernandezes have equity of $124,555 ($133,920 $9365), or a debt-to-equity ratio of 0.08 ($9365 $124,555).
The ratio of debt-to-equity method provides a quick idea of one’s financial solvency. The larger the ratio, the riskier the likelihood of repayment. A ratio in excess of 0.33 is considered high. The Hernandezes are well under that limit, unlike the result found by calculating their debt payments-to-disposable income ratio. This contrast occurs primarily because of their real estate investment asset, on which they have no debt.
Continuous-Debt Method
Another approach for determining your debt limit is the continuous-debt method. If you are unable to get completely out of debt every four years (except for a mortgage loan), you probably lean on debt too heavily. You could be developing a credit lifestyle in which you will never eliminate debt and will continuously pay out substantial amounts of income for finance charges—likely $1000 or more per year
Dual-Earner Households Should Consider a Lower Debt Limit
Having two incomes in a household has its benefits. Two people, each of whom earns $32,000 per year, will gross $64,000, with a disposable personal income of around $48,000, or $4000 monthly. It may seem that the couple can afford a much higher level of debt than before the incomes were combined. While the guidelines given in Table 6.1 are realistic, they would allow a doubling of debt payments if the addition of a second earner doubled household earnings.
Many young couples adopt a lifestyle based on two incomes. Their spending grows in tandem with their rising incomes. After a while, they are spending and borrowing to the limit. This situation cannot go on forever, of course. Eventually they may begin to feel financially stressed and wonder, “How can we be so broke when we make so much money?” When a child comes along or a financial setback occurs, they may be in deep trouble. If one earner’s income is reduced, perhaps because of a need to take care of family responsibilities, debts that had been manageable with two incomes quickly become overwhelming. Couples should avoid taking on excessive debt. Instead, they should set a reasonable limit and build savings accounts and make investments early in their lives together. That will truly protect their future financial security
Where would you make reductions? Spending a few minutes changing the figures in Table 6.2 will give you an idea of your priorities and the size of the debt limit that you might establish. Note that the debt payments-to-disposable income method focuses on the amount of monthly debt repayment not the total debt. As a result, it also would be wise to consider the length of time that the severe financial situation caused by high debt payments might last. It could be years, many years.
Ratio of Debt-to-Equity Method
Another method for determining your debt limit involves calculating the ratio of your consumer debt to your assets. The debt-to-equity ratio is similar except that it uses the equity in a person’s assets (the amount by which the value of those assets exceeds debts), excluding the value of a primary residence and the first mortgage on that home. This ratio recognizes that mortgage debt does not get people into trouble. In fact, mortgage debt is backed up by excellent collateral—one’s own home.
From Table 3.3 on page 69, we see that the Hernandez family has assets of $133,920 ($4420 monetary assets; $20,500 tangible assets less the value of their home; and $109,000 investment assets). Their debts (excluding their home mortgage) total $9365 ($120 $1545 $7700). With $9365 in debts and $133,920 in assets, the Hernandezes have equity of $124,555 ($133,920 $9365), or a debt-to-equity ratio of 0.08 ($9365 $124,555).
The ratio of debt-to-equity method provides a quick idea of one’s financial solvency. The larger the ratio, the riskier the likelihood of repayment. A ratio in excess of 0.33 is considered high. The Hernandezes are well under that limit, unlike the result found by calculating their debt payments-to-disposable income ratio. This contrast occurs primarily because of their real estate investment asset, on which they have no debt.
Continuous-Debt Method
Another approach for determining your debt limit is the continuous-debt method. If you are unable to get completely out of debt every four years (except for a mortgage loan), you probably lean on debt too heavily. You could be developing a credit lifestyle in which you will never eliminate debt and will continuously pay out substantial amounts of income for finance charges—likely $1000 or more per year
Dual-Earner Households Should Consider a Lower Debt Limit
Having two incomes in a household has its benefits. Two people, each of whom earns $32,000 per year, will gross $64,000, with a disposable personal income of around $48,000, or $4000 monthly. It may seem that the couple can afford a much higher level of debt than before the incomes were combined. While the guidelines given in Table 6.1 are realistic, they would allow a doubling of debt payments if the addition of a second earner doubled household earnings.
Many young couples adopt a lifestyle based on two incomes. Their spending grows in tandem with their rising incomes. After a while, they are spending and borrowing to the limit. This situation cannot go on forever, of course. Eventually they may begin to feel financially stressed and wonder, “How can we be so broke when we make so much money?” When a child comes along or a financial setback occurs, they may be in deep trouble. If one earner’s income is reduced, perhaps because of a need to take care of family responsibilities, debts that had been manageable with two incomes quickly become overwhelming. Couples should avoid taking on excessive debt. Instead, they should set a reasonable limit and build savings accounts and make investments early in their lives together. That will truly protect their future financial security
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