Take on Debt You Can Handle

Do you know why you’re in debt? A recent survey here at Talk About Debt reveals that the majority of people (55%) are in debt because they took on more debt than they could handle. That’s not a hard problem to fix. While you can’t go back and change the way you did things the first time around, you could end up in debt again after you’ve worked hard to pay your way out. That’s why it’s important to learn good debt management skills – to keep from going back into debt.

A lot of people completely swear off debt once they’ve made it out. They cut up the credit cards and vow never to take out another loan. But if you never take on debt again, how would you be able to buy a house or a car? It’s unreasonable to think you’d be able to save up enough money to make purchases that large. Unless you have a lot of money, it’ll be hard to avoid taking on debt. The key is to figure out how much debt you can afford and only take on that amount.

How do you figure out the amount of debt you can afford? Work strictly with numbers. Don’t rely on how you feel or what you think you could handle. Feelings and assumptions will lead you astray. Numbers don’t lie.

First, think about the amount you want to borrow. Then, compare that to your current income and expenses. A budget makes this step a lot easier. If you don’t already have one, you can create one now.

A budget holds all the information you need to determine whether you can afford more debt. The key number to pay attention to is your net income. That’s the amount you have left over after you’ve received all your income and paid all your bills for the month. By looking at your net income, you can easily figure out if you can afford to take on a new bill or not.

So, if you’re considering a credit card purchase, compare the amount of the purchase directly to your net income. If the purchase is more than your net income, you can’t afford to make it (because you should be paying your credit card bills in full every month). You might rationalize that you can pay back a larger credit card balance over a few months and technically, you can. But once you make a concession about the amount you can charge on your credit card, it’ll be easy to make others. When you make credit card purchases, you have to be disciplined. Set a maximum purchase amount, don’t go over it, and pay the balance in full at the end of the billing cycle.

When you plan to take out a loan, you could make sure the monthly payment fits in your budget. Is your net income high enough to cover the net payment? If the answer is “no”, then you should look at cutting your expenses before you fill out an application. What will the loan affect your debt-to-income ratio? Your debt-to-income ratio is the percent of your income that’s spent on debt. To calculate yours, add up your total monthly debt payments and divide by your total monthly income, then multiply by 100. The result is a percent. If your ratio is more than close to or more than 40% you can’t afford a new loan, even if you have enough income to cover the new loan payment. Instead of taking on additional debt, you should use some of your income to pay off the debt you already have.

As you decide think about taking on new debt, here are some other things to consider:

Your credit card debt should be paid off. If you already have credit card debt, you should focus on paying off that debt before adopting another expense.

You should have an emergency fund. An emergency fund is there to help you pay for unexpected expenses. Build your emergency fund before you apply for a new loan or credit card. That way, you can fall back on savings (instead of debt) in the case of an emergency.