How Much Debt Can You Handle?

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In life there are times when the need arises to make a purchase even though the funds are not available. This results in the need to borrow from someone who has excess money and willing to lend it with the stipulation of interest due. The concept of debt has been documented going back four thousand years to Babylon when loans were being made between temples and merchants. The ability to handle debt was as necessary in early history as it is now—maybe even more so.  In ancient Greece, for instance, if a man could not pay his debts, he, his wife and children would be forced into servitude until their labor paid off the loan. With interest constantly accruing, one loan default could result in many generations being enslaved. Today laws protect borrowers from such harsh consequences, but if debt is not handled correctly, debtors may feel they are just one step from that same sentence of servitude. 

 
The amount of debt one can handle is dependent on individual situations but there are some well-respected guidelines that can be used to gauge where one stands where debt accumulation is concerned. For most of us, debt always will be part of our lives but with proper management it can be controlled. 
 
The first step is to sit down with a piece of paper and write down the debts you pay down on a monthly basis, i.e. the mortgage, car loan, student loan or credit cards. Add these payments to determine the amount of money going towards your monthly debt repayment. Now determine your monthly income on a pretax basis by taking your annual salary and dividing it by twelve. With your monthly income and monthly debt amount in front of you, calculate the ratio of debt to income by dividing the monthly debt amount by the monthly income amount. This will yield a ratio of how much of your income is being allocated towards your debt. In a “good” financial situation, this ratio should be below 30 percent; up to 36 percent in an “okay” situation, but if it is above 36 percent, your credit score will be negatively affected. When it approaches 40 percent, it is beginning to take a turn for the worst. At 50 percent there has to be drastic change or certain financial ruin is in the near future. You should be aiming for a debt to income ratio of below 30 percent, so think twice about purchases if it will take the ratio to or above 36 percent.
 
One type of debt-to-income ratio does not necessarily determine how much debt you can handle. Finances are never that simple and different situations should be looked at differently. For instance, one person may have the luxury of living rent/mortgage free while another person may have multiple dependents and a mortgage affecting their tax rate. The debt-to-discretionary income ratio takes these factors into account. This ratio is calculated by determining what monthly expenses are necessary versus which are discretionary. Things such as rent/mortgage, food, utilities or transportation are necessary for living. Take this monthly expense and subtract it from your after tax income or the amount of monthly pay that you’re able to deposit in your bank account. This figure is your discretionary income, as it is not necessary to spend but could be spent by the individual to live a certain lifestyle. 
 
The minimum monthly amount due on revolving debt such as credit cards can be divided by discretionary income to arrive at the new ratio. This number would ideally be below 20 percent, but up to 25 percent is still okay. When this ratio crosses 33 percent the warning bells should begin to sound that the debt is beginning to be too much. At 40 percent a serious analysis of spending and prioritizing should take place. Approaching 50 and 60 percent signals that lifestyle changes need to be made or those changes will be made for you in the form of cash flow problems.
 
Knowing how much debt you can handle requires an understanding of how much money is coming in and how it is going out. While some may feel the pressure of debt pushing down on them, sitting back and not taking action is setting up failure. Ignoring a debt problem will not make it go away, but taking proactive steps in monitoring one’s debt level will help to determine if there is a problem or when one might be approaching.
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