While the perfect amount of debt is no debt at all, there is a limit that we should avoid breaching if we want to avoid falling into a spiral of debt. Debt counselling firms find that consumers tend to start running into trouble once their debt repayments exceed around 40% of their take-home pay. This is particularly true if the majority of repayments are for short-term debts such as personal loans, credit cards and car finance.
For most of us, credit is a way of life as it allows us to have what we need today, but cannot afford to pay for with our current savings. The problems begin when we start borrowing for “wants” rather than “needs”. Borrowing for a “need” would typically fall into the categories of housing (a home loan), transport (car finance) and education (a student loan). Our day-to-day needs, such as food and clothing, should not be paid for with credit, but should rather form part of our monthly budget.
In a perfect world we would not have personal loans or credit card debt, but these credit lines may be necessary to cover other needs such as starting a small business or home renovations, or emergencies like medical bills. It is when we start using credit lines because we are constantly living beyond our means, that we fall into a spiral of debt. Once you are spending 40% of your income on repaying debt, you’re left with little room to manoeuvre in the case of an emergency.
Debt counsellors reveal that most people end up over-indebted due to emergencies. They find themselves beyond the 40% limit and in financial crisis as they push loans out further or start missing repayments. As their affordability declines and risk profile increases, they are forced to take more expensive loans, worsening the debt cycle.
So what is a manageable debt level? This would depend on your personal circumstances and other obligations, but one can work on a rule of thumb.
A home loan is considered a “healthier” debt than short-term debt, because it’s used to purchase an asset that increases in value. Someone with a home loan could, therefore, have a higher debt repayment threshold than someone who has only short-term debt.
If, for example, your home loan repayment is 30% of your take-home income, you could have another 10% in the form of car finance and other loans. However, if your debts are all short-term in nature, including car finance, personal loans and credit card debt, you should aim to keep these at 25% or less of your income, but if absolutely necessary the maximum you should have is 35%.
Understanding your total debt levels is important as all other short-term debt such as personal loans and credit cards could prevent you from acquiring assets such as a car or home. Your total debt repayment levels should also be kept in mind when it comes to financing a car, as this could, in turn, impact your ability to purchase a home.
If debt repayments are already making up a significant amount of your budget, start paying off the shorter-term loans before you consider taking on longer-term debt, such as a home loan. Remember that a credit provider will give you as large a loan as they feel comfortable with, but that does not mean you will be comfortable with that much debt.
Courtesy of Liberty Life