Personal Financial Planning: An "How-To" Guide (part 29)

How Much Credit Can You Stand?

by

Charles Lamson

Sound financial planning dictates that if you are going to use credit, you should have a good idea of how much you can comfortably tolerate. The easiest way to avoid repayment problems and ensure that your borrowing will not place an undue strain on your monthly budget is to limit the use of credit to your ability to repay the debt! A useful credit guideline (and one widely used by lenders) is to make sure your monthly repayment burden does not exceed 20 percent of your monthly take-home pay. Most experts, however, regard the 20 percent figure, as the maximum debt burden and strongly recommend debt safety ratios closer to 10 to 15 percent---perhaps even lower if you plan on applying for a new mortgage in the near future. Note that the monthly repayment burden here does include payments on your credit cards, but excludes your monthly mortgage obligation.

To illustrate, consider someone who takes home $2,500 a month. Using a 20 percent ratio, she should have monthly consumer credit payments of no more than $500---that is, $2,500 x .20 = $500. This is the maximum amount of her monthly disposable income she should have to use to pay off both personal loans and other forms of consumer credit (such as credit cards and education loans). This, of course, is not the maximum amount of consumer credit she can have outstanding---in fact, her total consumer indebtedness can, and likely would, be considerably larger. The key factor is that with her income level, her payments on this type of debt should not exceed $500 a month. 

Exhibit 1 provides a summary of low (10 percent)), manageable (15 percent), and maximum (20 percent)) monthly credit payments for a number of income levels. Obviously, the closer your total monthly payments are to your desired debt safety ratio, the less future borrowing you can undertake. Conversely, the lower the debt safety ratio, the better shape you're in, creditwise, and the easier it should be for you to service your outstanding consumer debt.

You can compute the debt safety ratio as follows::

Debt safety ratio = Total monthly consumer credit payments / monthly take-home pay

 This measure is the focus of Worksheet 1, which provides a vehicle for keeping close tabs on your own debt safety ratio. It shows the impact that each new loan you take out, or credit card you sign up for, has on this important measure of creditworthiness. Consider, for example, Jack and Shelly Bitman. As seen in Worksheet 1, they have five outstanding consumer loans, plus they are carrying balances on three credit cards. All totaled, these eight obligations require monthly payments of almost $740 which accounts for about 1/5 of their combined take-home pay and gives them a debt safety ratio of 18 percent. And note toward the bottom of the worksheet that if the Bitmans want to lower this ratio to, say, 15 percent, they are going to either have to get their monthly payments down to $615, or increase their take-home pay to over $4,900 a month.

Click to enlarge.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN,  MICHAEL D. JOEHNK, PGS. 232-234*

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