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.
In pictures:
Major credit card mistakes
8 steps to dig out of 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.
Easy-credit nation
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?
In pictures:
9 ways to go bankrupt
How to make your first million
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:
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.)
Example: 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. | ||||||||||||||||||||||||
| Example: 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:
|
Example: 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%). | |||||||||||||||||