You Can Be Debt Free

HE-716, Revised January 1998. Fred E. Waddell, Extension Family Resource Management Specialist, Associate Professor, Human Development and Family Studies, Auburn University; and Robert W. White, Associate County Extension Coordinator.

Credit is an easy trap. Unplanned decisions about how we spend our limited cash resources and careless use of credit can limit our financial freedom. Credit advertisements would have us believe that with credit we can "have it all, right away!" But depending on credit can slowly rob us of our financial freedom.

Have you taken a close look at your spending lately? Do you find yourself charging items that used to be cash purchases? Do you make only minimum payments to creditors or skip payments when allowed? Have you requested increases in credit lines or been turned down on recent credit applications? Have you considered making a consolidation loan? Have you considered filing for bankruptcy?

Anyone can be caught in the credit trap. Almost one in every five Americans presently has a level of personal debt that is overwhelming. How much is too much?

How Much Debt Can You Afford?

It is important to know how much credit you can afford. Just because you receive credit offers does not mean you can make the payments. To figure out how much money you have available for credit payments, you need to know:

• Your total monthly take-home pay (net income).
• Your total monthly expenses, not counting any non-mortgage credit payments.

Your total monthly expenses fall in two groups: fixed expenses and flexible expenses. Fixed expenses, such as savings, utilities, and rent or mortgage payments, are the same each month. Flexible expenses, such as recreation or food, change throughout the month or seasonally. Total monthly expenses also include any money put aside each month for annual events, such as Christmas or a vacation.

Once you determine your total monthly take-home pay and your total monthly expenses, you can figure out how much money you have available for credit payments. Simply subtract the monthly fixed and flexible expenses from the monthly net pay. If there is some money left over, consider this amount as a maximum for credit payments for personal debt, not including mortgage payments.

Checking Your Debt Limit

Are you concerned that you may have more debt than you can handle? To see if your debt is within safe limits, check your debt rate. There are several ways to see if your monthly credit payments are taking too much of your income.

Method 1

One way to check your debt rate is to compare your hourly wage against your total debt, not including mortgage or rent. Read across the top line of credit limits in Table 1. Select the amount closest to your total debt. Next, read down the left hand column of hourly wages. Select the wage closest to your own. Follow down the debt column and across the wage line. Where the column and the line meet is a single number. That value is the number of hours you will work just to pay the annual interest on the debt if you make only minimum payments.

For example, given a total debt of $3,500 and an hourly wage of $9, you will work 78 hours just to pay the interest. Can you do without two weeks pay? If not, this may be more credit than you can afford.

When 40 work hours (or close to one week's pay) are needed to pay only the interest on a debt, then you have a 10 percent debt rate. Each additional 40 hours adds 10 percent to the rate. For example, a total debt load of $7,000 and an hourly wage of $9 shows 156 work hours are needed just to pay the interest on the debt. That is four weeks' income and is a 40 percent debt rate. It does not take much credit to quickly have too much debt.

Table 1. The Time-Is-Money Calculator.*

Total Non-Mortgage Credit Balance
$/hr	500	1,000	1,500	2,000	2,500	3,000	3,500	4,000	4,500	5,000	5,500	6,000	6,500	7,000	7,500	8,000	8,500	9,000	9,000	10,000
4.25	24	47	71	94	118	141	165	188	212	235	259	282	306	329	353	376	400	424	447	471
4.50	22	44	67	89	111	133	156	178	200	222	244	267	289	311	333	356	378	400	422	444
5.00	20	40	60	80	100	120	140	160	180	200	220	240	260	280	300	320	340	360	380	400
5.50	18	36	55	73	91	109	127	145	164	182	200	218	236	255	273	291	309	327	345	364
6.00	17	33	50	67	83	100	117	133	150	167	183	200	217	233	250	267	283	300	317	333
6.50	15	31	46	62	77	92	108	123	138	154	169	185	200	215	231	246	262	277	292	308
7.00	14	29	43	57	71	86	100	114	129	143	157	171	186	200	214	229	243	257	271	286
7.50	13	27	40	53	67	80	93	107	120	133	147	160	173	187	200	213	227	240	253	267
8.00	13	25	38	50	63	75	88	100	113	125	138	150	163	175	188	200	213	225	238	250
8.50	12	24	35	47	59	71	82	94	106	118	129	141	153	165	176	188	200	212	224	235
9.00	11	22	33	44	56	67	78	89	100	111	122	133	144	156	167	178	189	200	211	222
9.50	11	21	32	42	53	63	74	84	95	105	116	126	137	147	158	168	179	189	200	211
10.00	10	20	30	40	50	60	70	80	90	100	110	120	130	140	150	160	170	180	190	200
10.50	10	19	29	38	48	57	67	76	86	95	105	114	124	133	143	152	162	171	181	190
11.00	9	18	27	36	45	55	64	73	82	91	100	109	118	127	136	145	155	164	173	182
11.50	9	17	26	35	43	52	61	70	78	87	96	104	113	122	130	139	148	157	165	174
12.00	8	17	25	33	42	50	58	67	75	83	92	100	108	117	125	133	142	150	158	167
12.50	8	16	24	32	40	48	56	64	72	80	88	96	104	112	120	128	136	144	152	160
13.00	8	15	23	31	38	46	54	62	69	77	85	92	100	108	115	123	131	138	146	154
13.50	7	15	22	30	37	44	52	59	67	74	81	89	96	104	111	119	126	133	141	148
14.00	7	14	21	29	36	43	50	57	64	71	79	86	93	100	107	114	121	129	136	143
14.50	7	14	21	28	34	41	48	55	62	69	76	83	90	97	103	110	117	124	131	138
15.00	7	13	20	27	33	40	47	53	60	67	73	80	87	93	100	107	113	120	127	133
* Hours are calculated on net hourly wage. Interest rate is estimated at 20 percent annual.

Method 2

Here's another way to check your debt limit. Use Table 2 to see if your monthly credit payments are taking too much of your income.

First, find and circle the amount in the income column that is closest to your monthly take-home income. This net income is the usual amount of money you have after taxes, social security, and insurance are taken out each month.

Next, find and circle the amount in the debt payment column that is closest to the amount you usually pay each month. This amount should include every debt you make payments on except your rent or house payment.

Now, draw a straight line connecting the two amounts you circled. If the line goes down from the income column to the debt column, you are doing an excellent job of managing your credit! Less than 20 percent of your take-home pay is being used to pay debt. Think of this as a safe level of debt.

The line you drew may be almost level. That is about all the debt your income can handle. A level line means that about 20 percent of your net income each month is used to pay debts. Think of this as the most debt you can safely manage.

If the line you drew from the income column to the debt payment column is going up, more than 20 percent of all the money you take home is going to pay credit debt. Think of this as a dangerous amount of debt. The steeper the line, the greater the danger to your financial safety and security. You may be getting by from month to month right now, but a loss of income due to illness, job loss, divorce, medical expenses, or repairs for the car or house could mean real financial trouble.

Table 2. Comparing Net Income To Credit Payments.

Total Monthly Net Income	Total Monthly Credit Payments		Total Monthly Net Income	Total Monthly Credit Payments
8,000	1,600		3,750	750
7,750	1,550		3,500	700
7,500	1,500		3,250	650
7,250	1,450		3,000	600
7,000	1,400		2,750	550
6,750	1,350		2,500	500
6,500	1,300		2,250	450
6,250	1,250		2,000	400
6,000	1,200		1,750	350
5,750	1,150		1,500	300
5,500	1,100		1,250	250
5,250	1,050		1,000	200
5,000	1,000		750	150
4,750	950		500	100
4,500	900		250	50
4,250	850		0	0
4,000	800

Method 3

You can determine the risk of your current debt load -- with or without mortgage payments -- by following a few simple steps.

Calculating current debt load without mortgage payment:

1. List and total the required monthly payments on all credit cards and loans, including education and automobile loans. DO NOT include monthly mortgage payments.

2. List and total all of your net monthly income (take-home pay). Net monthly income is your gross income minus all required or standard deductions, including income taxes, social security, employer health and life insurance, union dues, and court-ordered child support payments if these are deducted from your wages. (NOTE: You may be able to increase your take-home pay if you are eligible for the Federal Earned Income Tax Credit. Call the Internal Revenue Service or your county Extension agent for more information.)

3. Divide required monthly payments by net monthly income. Move the decimal two places to the right. This figure is the percentage of your monthly income that you are using to pay off your total monthly debt (without mortgage payment). For example, if your required monthly payment is $500 and your net monthly income is $1,500, then 33 percent of your monthly income is going to pay off your debt. This 33 percent does not include mortgage payment or rent.

4. Use the Debt-Signals bar chart (left column) and the percentage limit for each zone to determine the degree of risk of your current debt load.

Calculating current debt load with mortgage payment:

• Add your monthly mortgage payment to your required monthly payments (figured in step 1 above).
• Divide this required monthly payment amount by net monthly income (figured in step 2 above). Move the decimal two places to right. This figure is the percentage of your monthly income that you are using to pay off your total monthly debt (with mortgage payment).
• Use the Debt-Signals bar chart (right column) to determine the credit risk of your current debt load including your mortgage.

Paying off debt is one of the best uses of your money you can find. Invest in yourself by paying off expensive debt. By paying off such debt, you would earn the equivalent of a whopping 25 percent annual interest if you are in the middle 28 percent tax bracket. This return exceeds any safe investment today.

How can you reduce your personal debt? There are several methods that work. Regardless of the method you choose, start by tracking your spending and setting up a monthly spending plan or budget. Once you have determined how much money you can pay towards the total debt each month, keep that amount fixed in the budget. You may reduce expenses and increase the payment, but do not reduce the total payment until all the debts are paid.

Method 1

List each debt from smallest to largest balance. Begin with the one that has the smallest balance. Write the minimum payment beside each. If your balance after expenses is not sufficient to meet all the minimum payments, you should get help with your finances immediately. Hopefully, you will be able to meet expenses and minimum payments with some money left over. If so, add this extra amount to the payment going to the first (smallest) balance listed. Each month, pay the extra money to this account until it is paid in full. When the first account is paid off, increase the total payment to the next smallest debt. Keep doing this until every credit account is paid in full!

Method 2

This method is similar to the first. Instead of listing the debts from smallest to largest, list them from shortest to longest length of scheduled payments. Installment loans for a car or furniture will be listed ahead of revolving accounts such as credit cards and department stores. Make scheduled payments to all accounts but add any extra money to the balance with the shortest term. Once the first account is paid in full, keep the budget amount for credit payments as is and apply extra money to the next account on the list. Do this until all accounts are paid in full.

Method 3

Arrange this list so that accounts with the highest interest rates are listed first. Set up a spending plan as you would for methods one or two. Make scheduled payments to each account but add any extra money to the payment going to the account with the highest interest rate. Continue this until all accounts are paid in full.

The Best Method For Reducing Debt

The best method for reducing debt is the one that works for you. Regardless of the method you select, it must be part of an overall spending plan. One method may save a little more than another. You may get a needed boost of confidence by paying off an account sooner than expected. Whatever the reason, the important thing is to take action to achieve your financial goals.

Where Can You Get Help?

For additional information, contact your county Extension office, or call Fred Waddell, Extension Family Resource Management Specialist, at 334-844-3244, or e-mail: fwaddell@humsci.auburn.edu

For more information, contact your county Extension office. Visit http://www.aces.edu/counties or look in your telephone directory under your county's name to find contact information. Issued in furtherance of Cooperative Extension work in agriculture and home economics, Acts of May 8 and June 30, 1914, and other related acts, in cooperation with the U.S. Department of Agriculture. The Alabama Cooperative Extension System (Alabama A&M University and Auburn University) offers educational programs, materials, and equal opportunity employment to all people without regard to race, color, national origin, religion, sex, age, veteran status, or disability.