A long-standing rule of thumb holds that monthly payments on debts (not including a home mortgage, which is really more of an investment) shouldn't exceed 20% of take-home pay. The closer you get to that 20% ceiling, the greater your risk of over-indebtedness.
Rules of thumb can be useful, but don't count on this one to keep you out of trouble. It says nothing about your total financial obligations or your level of income. If you take home $4,000 a month and live in a paid-up house, you can more easily afford $800 in monthly credit card bills than if you take home $2,000 and have to shell out $400 on top of the rent.
Whatever you make and whatever you owe, you probably have a pretty good idea of whether you're heading for trouble. Too much debt starts flashing these warning signals:
- It's taking extraordinary effort to pay your ordinary expenses. Perhaps you rely heavily on overtime pay or income from moonlighting, just to pay the rent and buy the groceries.
- You've picked up the habit of paying only the minimum due on your credit card bills each month, and sometimes you juggle payments, stalling one company to pay another.
- You can't save even small amounts and don't have enough set aside to get you through such setbacks as a pay cut, an unexpected car repair, or an emergency visit to your parents.
Even if you seem to be getting along fine, you should examine your debt situation occasionally.
Pay attention not only to how much you have to pay each month for credit card and other debt but also to how many months into the future you'll be stuck with those payments. If you quit using credit today, for example, how long would it take to pay off your nonmortgage debts? Six months? A year? Longer? Base it on these considerations: How secure is your income? Can you count on raises every year? How far down the road have payments on today's debts pushed the starting date for an investment program?
Set a debt limit that considers what you can afford today and, just as important, what today's obligations are borrowing from tomorrow. If debt is a problem, solving it should go right to the top of your list of financial priorities.