Avoid Being Overextended on Credit

I’m not so naive think that the majority of us will go through life without debt.  Nor have I personally been privileged or frugal enough to live debt free.  So assuming one is fortunate enough to avoid a crisis like job loss or health issues, how much can one really afford to borrow?

 The answer to that question will vary depending on whether you’re the lender or the borrower.  Among other tools, lenders use a Total Debt Service Ratio to calculate how much they are willing to lend.  To calculate your ratio, add up how much you pay per month for your rent or mortgage, property taxes, heating costs, loan payments, car loan payments and minimum credit card payments.  The total should be no more than 40% of your gross monthly income.

If a lender turns you down because your debt service ratio is too high then put on the brakes – it’s time to pay down your existing debt before you borrow more money.  Also, keep in mind that the 40% ratio is the maximum guideline and is almost always more than most of us can comfortably manage.  In addition, the Total Debt Service Ratio considers only rent or mortgage, property taxes, heat and minimum monthly debt payments.  We all know that this does not reflect the true reality of our expenses.  If you want to sit and stare at the four walls of your empty, unfurnished new house, or never be able to put gas in your new car, order a pizza, or take a family vacation then maybe the 40% maximum is for you.  If; however, you want to take a different path then you must ask, “Does this fit comfortably into my budget?”

To calculate whether or not borrowing money fits into your budget you must first determine your true cost of living.  Incorporate the cost of your groceries, daycare, gas, car insurance, phone, cable and all of your other regular monthly bills.  Moreover, factor in “irregular expenses”, that is, expenses that happen maybe once a year or once every few months for example:

Medical and dental expenses
Clothing
Sports Programs
Christmas & Birthdays
Back to school items
Car Repairs
Vacations
Vet Bills

Calculating irregular expenses can be complex and it won’t be perfect since life will throw curve balls, but estimating something is better than pretending these expenses don’t exist.  Once you estimate how much your irregular expenses cost in the year, divide that amount by 12 and add it to your regular, ongoing monthly expenses to arrive at your true cost of living.  This will help you more accurately calculate how much debt you can comfortably service.

And speaking of those curve balls, it’s also important to ask yourself:

Is my job stable?
How is my health?
Do we plan on expanding our family?
Will I still be able to save for retirement?
Will I still be able to afford this if interest rates go up?
Will this debt impair my ability to borrow or save for something that is more important to me?

In addition to the above, don’t forget the basics like calculating the true cost of borrowing by considering the interest rate, additional fees and length of time to pay it off.

I’m not trying to be an alarmist by posing these questions.  Financial maturity means making financial decisions with your eyes wide open.  You must consider all the factors to limit your risk and hopefully maintain financial stability.  This exercise may prove to be overwhelming and disheartening because you may discover a need to make changes to your budget or that you have to delay or modify your goal.  Even though it can be scary, consider the alternative.  The alternative is to make the really big financial decisions in life by looking at only half the picture.  The alternative is to let a ratio that can’t possibly factor in human nature or what is important to you and your family calculate how much you can afford!  The financial decision you make in a few minutes can affect the next 5-25 years of your life so isn’t it worth spending some time to do the math?

By:  Brenda D.  Owens, Trustee in Bankruptcy


Brenda works for James R. Yanch, Trustee in Bankruptcy
215 Simcoe St. N.
Oshawa, Ontario
L1G 4T1
905-721-7506
www.jamesryanch.com