We speak to several people about personal finance and one of the more common issues we encounter is they do not know how to evaluate if they already have too much debt or if a new loan will put them over the edge. In many cases, they rely on a bank to “tell” them based on the amount of loan the bank is willing to provide. We could hear the conversation: someone asks, “how much are you going to borrow?”, and the response, “I don’t know; let me see how much the bank will give me”.
Don’t get us wrong, EVERYONE knows they should only borrow what they could afford to repay, and they KNOW they have too much debt when they are struggling to repay.
So if everyone knows the basic premise is affordability, why do we get to a point where we could struggle to repay? Note, we are not referring to situations where persons lose their jobs or are unable to work; obviously paying loans in those circumstances could be difficult.
We suggest the reasons for this disconnect could be because they:
- Overestimate what they could afford
- Do not plan for unforeseen events
- Allow themselves to be influenced by non-financial considerations
- Are unprepared for a conversation with a bank/lender
- Underestimate the impact of defaulting on a loan
So what should the approach be? It’s actually simpler than you think.
Only your budget matters
Too many people believe they are living by a budget when they know they earn X and spend Y. This is not a budget, rather a list of income and expenses. A budget is when we make deliberate decisions how to reconfigure our expenses (usually easier to change than income) to deliver a targeted level of savings.
In the Tools section, we provided a sample budget spreadsheet that could be used to create your own budget. This spreadsheet was set up in four sections: Income, Fixed expenses, Discretionary expenses, and Savings. If you haven’t read those articles, we suggest you open the Cari$ Sample Budget to better understand these comments (by the way, WHY haven’t you read those articles yet?).
We recommend to set up your budget in such a way that you aim to allocate your income using our 33/33/33 approach. This means 33% of your income should cover Fixed expenses; 33% should cover Discretionary expenses; and 33% should be saved. Take a look at Creating Your Budget (33/33/33) to get more information.
Allocate 33% of income to Fixed expenses
But you need to pay attention to the Fixed payments section. It does NOT only include loans. Most of us only equate fixed payments with loan payments. But the reality is, quite a few payments we make are “fixed” every month, meaning they don’t vary often or by large amounts. We therefore have less opportunity to control these. This is in contrast to Discretionary expenses, which we are able to reduce when needed.
Because the 33% allocated to Fixed payments includes more than loan payments, it is likely the loan portion by itself is closer to 25% of your income, which is probably a good rule-of-thumb to use. This means, take your after-tax income and multiply it by 25% and this amount is probably the most you should pay on just loans. This is just a rough guide to know when you should really start paying attention.
Factor in unexpected events
All too often we determine how much we can afford to repay based on our current circumstances, but we really should pause to consider if there are any unexpected events we should factor into our decision. If these events occur, they could put pressure on our ability to repay.
A simple example might be a married couple basing their repayment ability on their combined income. They really should consider what could happen if one spouse loses their job and the replacement job pays less. Persons on contract should obviously think about the likelihood of their contract not being renewed. We hope you get the point.
The idea is simply to think about what bad things could happen, and the greater the likelihood of the event happening should lead you to having a LOWER amount of debt.
There is just no room for emotion in financial decisions. Money is either there or it isn’t. But we all allow ourselves to be influenced by desire sometimes e.g. buying a more expensive house than you should because it has some dream feature (e.g. a pool) or the location is great. We stretch ourselves just a little bit more to get that more expensive car or pay for a great Cancun vacation when we really should happily think Tobago.
Whatever the example, we have all been in that situation. The only way to prevent a natural emotional tug from influencing your decisions is to evaluate what you can afford FIRST. Then when you start to look or get prices, you have a clear high and low range that you can afford and then it’s up to you to stick to it. Even if it hurts a little to walk away…
It’s serious business if you default on your loan, apart from just losing any collateral you may have put up. You are likely locked out from being able to access credit from any lender, and it’ll be impossible to get a job if prospective employers ask for a credit check before they hire you.
The point is, it should never reach this stage, or even to a point where you are struggling, once you use your budget and the tips we gave above.
If the loan amount you can afford is less than what you actually need to make a purchase, just step back and save a little more to make up the difference. If this is not possible, then you need to take a hard look at your budget and cut back on expenses to make the additional loan payments fit into the 33% allocation.
In Part 2…
In How Much is Enough Debt? – Part 2 of this post, we’ll continue the discussion and also give you some tips how to prepare for a discussion with a lender.
Do you have any experiences to share? We’ll love to hear from you in the comments below!