With interest rates at historic lows, borrowing has never looked so good to so many. But you don't want to overdo it and end up on debt row. How much debt is too much? Which loans are simply smart uses of credit? To help you make the right debt decisions, we will show you where your mortgage, car, credit card and education debt levels should be and explain the best way to manage your personal debts.

It's almost impossible to live debt-free; most of us can't pay cash for our homes, cars or children's university tuition fees (especially abroad). But too many of us let debt get out of hand. Ideally, experts say, your total monthly long-term debt payments including your mortgage and credit cards should not exceed 36% of your gross monthly income. That's one factor bankers consider when assessing the creditworthiness of a potential borrower.

At the other end of the scale, avoiding debt at any cost is not smart either if it means depleting your cash reserves for emergencies. The challenge is learning how to judge which debt makes sense and which does not, and then wisely manage the money you do borrow.

But before we get going, let's do a little quiz to see if you do have problems with your personal debt. (Box)

1. Is your monthly mortgage payment (including insurance) more than 28% of your monthly gross income?

(A) Yes (5 points)
(B) No  (0 point)

2. Is your auto payment more than 15% of your monthly net income

(A) Yes (5 points)
(B) No  (0 point)

3. Compare the balance on each of your credit cards to its respective credit limit. Then compare the total of all your card balances to your total limit

(A) Below 50% (0 points)
(B) For each account above 50% (5 points)

(C) If your total balance is more than 50% of your total credit limit (15 points)

4. Add up all your monthly loan payments and divide it by your gross monthly income to see what percentage of your money is going to debt.

(A) Below 30% (0 points)
(B) 30-35% (5 points)
(C) 36-40% (10 points)
(D) Over40% (20 points)

5. Do you have an emergency fund that can cover at least 3 month's worth of all debt payments, plus your other living expenses?

(A) No (10 points)
(B) Only 1-2 month's worth (5 points)
(C) Yes (0 points)

6. Have you been late on a loan payment in the past 6 months?

(A) Yes (10 points)
(B) No (0 point)

7. In the past 2 years, have you looked into refinancing and calculated whether you would save money?

(A) Yes (10 points)
(B) No (0 point)

8. Have you checked your credit report in the past 12 months?

(A) Yes (10 points)
(B) No (0 point)

Your scores  =

If you score less than 10 points then you don't need to read any further because you are managing your debt quite well. But if your score is between 15 – 30 points, you are managing your debt fairly well but you need to stay vigilant. Those with over 30 points, I suggest that you read on because you've definitely got problems.

Quite often the decision to borrow doesn't hinge on how much cash you have but on whether there are ways to make your money work harder for you. In a low interest rate environment like now, try comparing your interest expenses on a loan versus what your money could earn if it were invested. If you think you can get a higher return from investing your cash than what you will pay in interest on a loan, then borrowing may make sense. Here are a few tips on how to make the most of your personal debt.


Total Debt

  As a rule of thumb for most financial institutions, the maximum lending limit on personal loans depends on your income and it is usually capped at 36% of your net income. However, due to the intensity of the competition in the market place, some financial institutions are willing to waive the monthly installment to as low as 40% of net income. But the question is whether is it prudent for you to take on that much debt in the first place.

The data in the pie chart can be used as a reference guide in managing your personal debt. Assuming that your personal income tax is in the 25% bracket; you will need about 20% of your income for monthly expenses and may be 15% of savings. This would leave about 40% for debt installments. Realistically speaking, anyone exceeding the 40% limit will find it very tough to get out of the vicious circle of personal debts.

Home Loans

Unless you are a millionaire, the chance that you can pay for a new home in cash is slim. Therefore, when you are taking out a home loan, it may seem logical to put down as much as possible on your down payment in order to minimize your interest payments, but this is not always the best move. You need to consider other issues, such as your need for cash reserves and what your investments are earning. Although, mortgages tend to have lower interest rates than other debt and they are tax deductible as well, but it is not wise to pour all your cash into a home if you have other debt. A 20% down payment is usually the norm in getting the best mortgage deals

Student Loans

  When it comes to paying your children's higher education, allowing your children to take out loans may make more sense than liquidating or borrowing against your retirement fund. The reason being that they have plenty of financial resources to draw on for college but no one is going to give you a scholarship for your retirement. Your best bet is to save what you can for your kid's educations without compromising your own financial health. Then let your kids borrow what you can't provide, especially if they are eligible for students loans and scholarships. Student borrowers can generally handle payments of up to 12 % of their income. But how much you, the parents, should borrow for college, however, is tough to pin down. It's really a balancing act but the main aim is to get out of debt before retirement. For more on education financing, please see refer to M&W July 2003 edition.

Auto Loans

Figuring out the best way to finance a car depends on how long you plan to keep it, since a car's value plummets as soon as you drive it off the show room. It also depends on how much cash you have on hand. If you can pay for the car outright, it make sense to do so if you plan to keep it for a very long time or longer than the term of the loan. It's also a smart use of cash if that money is unlikely to earn more invested than what you would pay in loan interest. The current low interest rate environment being a case in point.

Most people (i.e. you and me), however, can't afford to put down 100% on a new car. So the goal is to put down as much as possible without jeopardizing your other financial goals and emergency fund. Typically you won't be able to get a car loan without putting down at least 10%. A loan makes most sense if you want to buy a new car and plan to keep driving it long after your loan payments have stopped.

As with mortgages, banks will lend you much more for car loans than you should necessarily borrow. Your car payments can equal up to 20% of your gross income. But young, lower income car buyers might need to borrow more for a new car, but that's rather indulgent for most of us; after all, cars are depreciating asset. Personally, I would suggest that your car payment should be no more than 15% of your net income as long as you don't have other large debts besides your mortgage.

The 0% interest car loan can be a great deal, but approach with caution because these loans are really offered in lieu of a cash rebate. So before you jump on a free loan, figure out whether you would save more by arranging your own low-rate loan and applying the cash rebate to your down payment.

Credit Cards Loans

  When it comes to revolving credit card debt, your goals should always be zero. Of course, moving towards zero isn't always easy, even among people with higher incomes. Credit card debt can be a necessary evil—if, say, unexpected medical expenses crop up but in theory, you should have emergency savings fund for those purposes. At the very least, do not carry balances of more than 50% of your limit. And if any of your credit cards are maxed out, you may need to temporarily break the old rule of paying off the highest-rate card first. Instead, you should pay down the maxed out one first.

The other word of caution is don't fall into the minimum trap. If you just pay the minimum due on credit-card bills, you will barely cover the interest you owe, to say nothing of the principal. At the current maximum rate of 18% pa., it will take you years to pay off your balance and potentially you will end up spending much more than the original amount you charged.

Getting out of debt

The basics of debt reduction are really quite simple but difficult to implement. First, you must cut down on luxury items dressed up as necessities and put the extra money toward your debt payments. Once you determine the maximum amount you can pay off each month, pay down the highest interest rate first; that usually means your credit card balance, while paying at least the minimum monthly amount due on all other revolving bills.

Once you have wiped out the debt with the highest rate, put your money toward paying the debt with the next highest rate. You might also consider moving some of your high-interest credit card balances to one card with a lower interest rate. But read the fine prints carefully, sometimes such low interest rates offers are only in effect for short periods of time. Some of you may be tempted to pay off credit card debt by borrowing from your provident funds, but this is not really advisable because if you quit or lose your job, you will probably have to repay the entire borrowed amount within 3 months, if not immediately.

For many people, reining in discretionary spending for a few months goes a long way toward tackling debt. But if that's not enough, try reduce your fixed expenses. Take steps to lower your household bills; refinance your mortgage to get a lower interest rate. Once you have paid off your credit card debt, you have to be vigilant about not running your balance up again, because you still have big loan payments to make. For budget tips please refer to M&W July 2003 issue.


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