How Much Credit Can You Actually Afford?

June 19, 2010

There many factors you should consider before making the decision to add more debt to your current financial situation. Above all you should start with the following prerequisites before you get that new credit card or car loan:

Make sure sufficient money is allocated for your essentials.
Borrow only for items that you need and can afford.
Borrow only if you are spending less each month than you take home.

With that in mind, lets start with some basics you should think about and assess before you plunge deeper in debt. This should help you come up with how much you can actually afford to spend on new debt.

1. Start with your monthly take-home pay.

This is the amount you’ve left after taxes and other deductions have been made.

2. Subtract the amount you need for necessities and fixed expenses.

This includes savings, your mortgage or rent payment, utilities, food, transportation, child care, medical care, clothing, and recreation. Include payments made on a quarterly, semi-annual, or annual basis, such insurance and taxes.

3. Subtract monthly payments for existing loans and credit cards.

4. The balance is the amount you can safely apply to debt repayment.

Avoid thinking you can spend the total amount, since emergencies do occur, and you might not wish to use your regular savings account to cover small, unexpected expenses.

So here is the formula you should use when taking on a new debt:

Pay After Tax - Fixed Expenses - Loans and Credit Cards = Amount Available For Additional Debt

If you’re planning to buy a new house or car, pretend you’ve already done so and begin “making the payment” but to yourself. Within a few months, you’ll know whether or not you can really afford it and you’ll have some money set aside for repairs, etc. when you actually do make the buy. If you can’t make the pretend payment, you certainly won’t be able to make the real one consistently. Time to go back to the drawing board and figure out what else you’re willing to give up in order to have the new debt.

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