Frugalnomics

While getting into debt should never be a goal of its own, it is imperative that you assess your ability to handle new debt every time you apply for a new line of credit. There is no magic number — like 60% of your income — that you can use to determine your ability to afford new debt. Rather, you must account for all current and forecasted obligations and balance those against your income.

Here are a few things to keep in mind when determining whether you can afford new debt:

1 – Keep an annual scope

Most car salespeople know a simple accounting trick to get us to buy: convince the prospective buyer that the new vehicle is within their monthly budget. This tool is extremely effective because it allows the salesperson to dodge the fact that not all expenses are billed monthly, helping the buyer take the planning of those expenses out of the picture.

There are simply too many expenses that occur less frequently, though, to fall for this trap. Car registration, computer security software, and magazine subscriptions only occur annually; many insurance plans and commodities only bill quarterly or semi-annually; many services are billed on an as-needed basis: all of these things must be budgeted for and must be part of the assessment.

2 – What Can You Afford?

Do not let the potential creditor determine what you can afford for you. This ties into the previous bullet, but refers specifically to the application process. You will always be offered more debt than you can afford, even with rigorous application processes. The application only takes into account your other legal obligations as reported in your credit report and your wages: it does not consider grocery costs, repair costs, and the myriad other financial obligations of your household.

For most of us, if we were to include all of the things we spend money on each month in the application, we would not be accepted for near as much credit. Instead of using the application as your metric, develop a specific budget based on all of your expenses and use that to determine how much money you have available for further obligations.

3 – Liquid Assets

How much money do you have in liquid assets? Liquid assets refers to any instrument or account in your possession which can be used as cash whenever and however you please. It can include your savings account, certificates of deposit, money markets, certain retirement plans, precious metals/stones, the cash under your mattress, and equity, among other things.

It is advisable that you have enough saved in liquid assets to cover all of your financial obligations for at least six months. If you have less than that amount, think twice before accepting new debt. If you have nothing saved in liquid assets do not get into any more debt until you start saving.

4 – The Big Picture

Look at the big picture, not just the prospective monthly payments. How many of us have ordered satellite television with the promise of “the first three months free” only to be charged high rates after the promotional period? This same tactic can catch you off guard in many other forms.

Variable Rate interest plans or Adjustable Rate Mortgages are prime examples. You may start with a payment that is within your comfort zone, but end up paying much more. When determining if a new debt is within your limits, take into account the upper limit of the payments when other interest rates are applied. If there is no upper limit to the interest rate do not accept that debt!

Another example is the “balloon payment.” Balloon payments occur when you agree to a fixed monthly payment for a fixed amount of time but have some other variable, usually that works against you, that can affect the total cost of the debt you are incurring. This often happens with auto loans and mortgages: at some point in the life of the loan different fees are applied, leaving you with a final payment much larger than the monthly payments before. Make sure you ask the loan officer offering you a new loan what balloon payments you may expect, account for that in your decision, and save for it through the life of the loan.

Final Thoughts

This is hardly an exhaustive list of all things you should consider when considering how much debt you can afford, but it will get you going in the right direction. If you are yet unsure whether you can afford a new debt, err on the side of caution; it may mean the difference between being able to buy food and avoid bankruptcy. For further assistance there are many financial advising agencies who can help you fully determine your financial position and whether you can afford new debt.