Finance kapoor personal: Avoiding debt shock
Debt has become a rubber band. Three-year car loans have stretched to four and five years; homeowners rush to take out revolving home-equity loans; credit-card balances are paid off more slowly. Although fitting debts into longer periods may keep monthly payments manageable, it can build a mountain of debt that buries any possibility of saving for emergencies, let alone for retirement or college.
Regularly winding down debts keeps the total load under control. One good way is to limit the term of all debts besides mortgage loans to three years and to fully pay off at least one credit-card balance each year. "A chart of your debts should show peaks and valleys; you're headed for trouble if all you see is an upward slope," says Jay Muzychenko, a vice president at the National Foundation for Consumer Credit, an organization of nonprofit credit-counseling offices that help overburdened borrowers deal with creditors at little or no fee. (You can find a local office by calling 800-388-2227.)
Defining the limit. Most people can afford to earmark up to 20 percent of their after-tax income for repaying debts other than home mortgages, say advisers. But a 15 percent limit provides a bigger buffer for setbacks such as the loss of a job, advises Jack Kapoor, a professor of business and economics at the College of DuPage in Glen Ellyn, Ill., and co-author of a personal-finance textbook.
Potential home buyers may want to be even more cautious. Many mortgage lenders apply a double test, in this case to before-tax income: They get edgy if more than 28 percent of your gross income will go toward mortgage payments or if your total debt payments, including mortgage payments, will eat up more than 36 percent of your income.
In determining the credit you can afford, all income doesn't carry the same weight. Borrowers court credit disaster by relying on income from a second job, a spouse who may stop working or other iffy sources. Overtime pay only counts if it is an ironclad part of your compensation, says Dixie Johnson, an associate professor at Purdue University's School of Consumer and Family Sciences.
When to say when. The worst reason to borrow is to keep up with rising expenses or falling income. Yet that is exactly what many people do. It is a compulsive attempt to avoid any change in their budgets, says Brett Williams, an anthropologist at American University in Washington, D.C. You know what credit counselors will say about that.
