Debt and Credit: Know Your Limits

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Managing credit comes with plenty of potential hazards. Stick to the rules of the road, and you should be OK. But, if you don't learn how to manage it wisely, you could end up in a pit of debt.

"Like driving, obtaining credit is a privilege, not a right," says J.J. Montanaro, CERTIFIED FINANCIAL PLANNER™ practitioner with USAA. "Too many people get deep into debt because they don't really understand how credit works. And once they get in, it's very hard to dig out."

Wonder if you're taking on too much debt? Use these guidelines from USAA financial advisers to check where you stand.

Type of Debt What It Includes What It Should Be
Consumer Debt Nonmortgage obligations, such as
credit cards, auto loans and
installment plans
20% of your
monthly after-tax
income
Mortgage Debt Mortgage payment, property taxes
and insurance
28% of your pre-
tax monthly
income
Total Mortgage property taxes
homeowners insurance, credit cards,
auto loans and installment plans
less than 36% of your pre-
tax monthly
income

To understand how to assess your own situation, let's look at an example. Rebecca bought a house last year and used her credit card to furnish it. Next, she bought a new car. After a few months, she became worried her debt was eating up too much of her income, which is $4,500 a month before taxes and $3,600 after federal and state taxes.

Rebecca applied the recommended guidelines to assess her situation. She quickly discovered that she was in a precarious situation.

Type of Debt Recommended
Limit
Rebecca's Debt Too Much Debt?
Consumer
Debt
(20% x $3,600 =
$720)
$900 worth of monthly
payments, or 25%
Yes
Mortgage
Debt
(28% x $4,500 =
$1,260)
$900 monthly mortgage
payment, or 20%
No
Total (36% x $4,500=
$1,620)
$1,800 in total monthly
payments, or 40%
Yes

"The good news is that Rebecca took time to crunch the numbers before things got worse," says Montanaro. "With facts in hand, she can make decisions to help turn around her finances and get back on track."

Plan Your Escape Route

If, like Rebecca, you find that you're headed down a bumpy financial road, you can still take control.

  1. Don't dig any deeper. Rebecca realized she needed to stop adding to her credit card balances immediately. She put away all her cards except one, to use only for emergencies.
  2. Stop accepting new credit offers. Rebecca was inundated with pre-approved credit card offers. She declined all of them.
  3. Find out where you stand. By using a debt calculator, Rebecca learned how to pay off her debts in the optimal sequence, starting with the account with the highest interest rate. She made a small exception to the rule by polishing off two low-balance accounts, providing a quick, morale-boosting victory in her war to drive down debt. She also visited www.annualcreditreport.com and verified that her credit reports were accurate by reviewing them for free.
  4. Avoid paying the minimums. Even if you are concentrating on one debt at a time, pay more than the minimum on each payment, which is usually only 2% to 3% of the total balance. Rebecca has found ways to reduce spending so that she could pay extra on her accounts each month.
  5. Build a snowball. As she retires each debt, Rebecca takes the money she was applying to it and moves on to her next target. By systematically attacking debt, she has created a snowball effect that gives her more debt-removing power with each balance she erases.
  6. Monitor and protect your credit. Reducing debt should improve your credit score — the number that lenders use to assess how much risk you present and what interest rate they charge. Rebecca now uses a service that lets her monitor her credit for a modest monthly fee.


Victory at the Finish Line

Establishing and maintaining good credit is important, but managing it is equally vital. "By taking control now, you should avoid paying a fortune in interest and have more resources to devote to other important financial goals, such as regularly contributing to your emergency fund, retirement savings and college savings for your kids," says Montanaro.

Related Topics

Personal Finances Credit Card Debt
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USAA, a diversified financial services organization, is the leading provider of competitively priced financial planning, insurance, investments, and banking products to members of the U.S. military and their eligible families. Rated among the highest among financial services companies for customer advocacy in a Forrester Research survey, USAA provides convenient and accessible financial products to its more than 9 million members. For more information about USAA, or to learn more about membership, visit usaa.com
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