Most budgeting articles tell you that debt is akin to death and credit cards are cancer. Sure, cutting debt out of your life completely is solid advice, but often it's a bit like telling a drowning man that water is bad for his lungs.
America has become the land of the free-to-charge. Debt is a fact of life for millions of U.S citizens. In this article we'll teach you to swim and help you create a disciplined system for monitoring personal debt. Specifically, this will help you define your "personal debt redline" - the point at which you should begin to think twice before charging up more debt.
Monitoring your total debt load against this line can become a useful discipline for developing effective budgeting and spending habits for life. This system recognizes that many people use debt productively to maintain their lifestyles and achieve personal goals. It's also simpler than many others, consisting of five steps.
Imagine yourself walking to the front of the checkout line in a store. You reach for a credit card to swipe. As your card glides through the scanner, a red light flashes and a buzzer blares. "There must be some mistake!" you cry out. "I'm not over my limit." Looking at you with deep concern, the cashier says, "True, but you are dangerously close to having too much credit in your LIFE! Maybe you should go easy on the charges for awhile."
Dare to dream. It would be great if life came with warnings like this, but unfortunately this scenario does not reflect the world of today. If one of your cards hits its credit limit - well, that's why wallets are made to hold several, right?
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From 1982 to 2007, the total US revolving credit (mostly charge cards) has increased from $65 billion to $920 billion. In 2007, Total US consumer credit outstanding (roughly all consumer debt less mortgages) soared to $2.5 trillion, or about $24,000 per U.S. household, according to the Federal Reserve. No other nation in history has become so indebted so fast, especially during times of relative prosperity.
In this easy-credit environment, some people intuitively have felt their personal debts start to spin out of control. But without a warning system, how can you know for sure that you have crossed the line? Follow these fives steps to define your line.
Step #1 - Focus on your discretionary spending and debt
"Discretionary" means you have some control over what you charge or borrow. Practically speaking, this means that, in this process, we will set aside debts over which you have little short-term control, such as home mortgages, car loans or leases. Those are important, but there may not be much you can do to manage them in the short-term. In this process, we will focus on credit/debt that you can avoid or adjust, if necessary.
Step #2 - Recognize that your debt should be in proportion to three important financial resources
Unless you are retired, you have three ways of building assets and/or repaying debts:
- Your savings, investments and "rainy-day" liquidity.
- Your job security and prospects for income growth.
- Your discretionary income, after necessary expenses.
If you are fully retired or otherwise not working, you won't be able to count on the second item above.
"Rainy-day" liquidity is money you could tap quickly and easily to tide you through a difficult period. Some financial advisors recommend having at least three to six months' worth of your average total monthly household expenses in such an emergency fund.
The first two points above are somewhat subjective, and household circumstances vary. For example, many younger households have not had time to build savings and investments - but they still have time on their side. Job security and prospects for income growth are often uncertain, so your attitude and confidence may be as important as objective facts or data. It may be useful to work with a professional financial advisor to evaluate the specific progress you are making in these three areas.
Step #3 - Rate your current situation in regard to the first two resources
First, you have to give yourself a progress rating. To do this, use a scale of 1-5, in which 1 = low progress and/or confidence and 5 = high progress and/or confidence. (Select the number in the table below that best applies.)
1. You feel that your savings, investments and "rainy-day" liquidity are about average - you rate this 3.
2. You feel that your job security and prospects for income growth are above average - you rate this 4.
Now add these two scores together. In the above example, the total is 7. Hold your measurement until Step 5.
Step #4 - Determine the discretionary income you can allocate to debt repayment
Sit down with a typical month's worth of income and spending data and determine the third financial resource - discretionary income. This is calculated by taking your total month's income and subtracting your expenses. For this purpose, do not count current debt payments (except for mortgage and auto) in the expenses. For example, do not count amounts that you send to credit card companies or repay on consumer loans. However, do count all necessary living expenses, such as for rent/mortgage, food, clothing, utilities, education, etc. Also, count any repayments made for debit cards, as these represent current expenses, not credit.
Suppose you have total monthly income of $5,000 and you determine that your necessary monthly expenses total $3,500. In that case, you have $1,500 of discretionary income that may be used for:
Note: Some households carry little or no debt on their homes or cars. This system recognizes their potential to increase other types of credit comfortably, because they often have relatively higher amounts of discretionary income.
Step #5 - Estimate Your Personal Debt Redline
Using the total score from Step #3, the guideline percentages in the table below will help to estimate the maximum portion of your monthly discretionary income that you should plan to allocate to repaying debts (principal + interest). By tracking the monthly amounts you actually pay for all debts (excluding home or car), you can then determine if you have exceeded your personal debt redline, and make any necessary adjustments.
Your total score in Step #3 was 7. Your monthly discretionary income in Step #4 was $1,500.
The table estimates that you will hit your debt redline when you are spending more than about 30% of your discretionary income to debt repayment. You should try to keep your monthly debt repayments below about $500 per month ($1,500 x 30%).
On revolving credit, such as credit cards, you should generally estimate your monthly debt repayments based on making somewhat more than the minimum required payments. This is because, by paying only the minimum, you may not escape debt in your lifetime.
The redline can move
While this exercise is somewhat subjective, it can help you realize two important points:
- When you have a disciplined way of monitoring debt repayment obligations, it's harder to slide gradually into a situation where you are in over your head.
- Your ability to carry debt depends on your progress and confidence at work and in building your savings, investments and rainy-day liquidity.
If you are married, it's a good idea for both spouses to separately evaluate the subjective questions in Step #3. Any differences in your thinking should be discussed and resolved. While it's not essential to monitor discretionary income (after necessary expenses) for more than a couple of months, you may find that this is a valuable budgeting discipline that you will want to continue.
The bottom line
Most debt management systems are like diets. They tell you what you can't do. This one is different because it begins by asking you to define your financial success and confidence. Taking charge of your debts now can be the key to maintaining good credit and strong financial progress for years to come. Know where your personal debt redline is - and do your best to walk the line.