From time to time, you may find yourself in a situation where expenses are greater than income. Emergency expenses, such as a bill for unexpected repairs or health care repayment, may be the cause. Without adequate savings, many people are forced to rely on credit, thereby creating debt, to settle accounts. In this article we will look at credit uses and the appropriate level of debt.
Credit is a financial tool, and like any tool it can be used correctly or incorrectly. You may have a number of reasons to use credit. Usually, a person uses credit because money is not available to buy something. The “something” may be a discretionary purchase, an emergency purchase, a large financial transaction, or similar items. These are not the only reasons people use credit, though.
Using a credit card is convenient. Monthly statements provide a good spending report. Using credit may keep a person from having to carry large amounts of cash, thereby limiting potential theft.
Some transactions, such as renting a car or booking an airline ticket, are nearly impossible to make without using a credit card. Additionally, at least with some credit cards, there is a degree of protection when a purchase turns out to be defective.
Credit can also be used as a source of emergency funds. Maintaining a reasonable cash reserve is a better practice. However, if the need is significant enough, you might not have enough money in the reserve. At such times, although this just postpones payment, using credit can provide a way through the emergency.
Things to Look Out for When Using Credit
Using credit has disadvantages as well as advantages. Spending too much is perhaps the biggest disadvantage. It is highly possible for a person to become overleveraged — that is, they owe more than they have the ability to repay. At an extreme, if a person accumulates too much debt, all future cash flow during the repayment period may be committed to paying down that debt.
Keeping an exact record of expenditures is a very good idea. This is especially true when credit is involved. Without controls, credit use can spiral out of control.
Making purchases using credit comes at a cost. Sometimes those costs can be quite high. Rather than focus only on whether you can make a monthly payment, it is good to consider interest costs, losing the use of future funds because they are being used to make debt payments, reducing overall capacity to borrow, total debt and similar concerns.
How Much Debt is Okay?
How much debt is acceptable? However much you can reasonably handle. Though that is a somewhat nebulous answer, it provides a starting point to determine realistically acceptable debt levels. Rules of thumb are helpful, but your specific reality is the real key. Two components must be explored: the amount of your total debt load and the amount of total monthly payments (debt service).
To measure the debt-to-asset ratio, divide total debt by total assets. A target for this ratio is 50 percent or less. Additionally, a good target for debt service is 35 percent or lower. The ratio divides annual debt repayments by annual net income. This means if your incoming cash flow is $1,000, your monthly debt payments should be no greater than $350. In each situation, it’s best to leave room for the unexpected.
A Better Option
Establishing a reserve fund to use rather than credit is one good reason to save. That’s also a part of the rationale used to endorse building emergency, or contingency, funds.
If you suddenly need new tires on your car, but you have no money with which to purchase them, credit may become the only available option. On the one hand, you have the new tires, and can safely continue driving to places you need to go. On the other hand, you now have several hundred dollars’ worth of new debt to add to your budget. If those tires cost $500, and you want to repay the debt within one year, you could easily be adding another $50 to your monthly budget. While $50 doesn’t seem like much, if your monthly outflows already are close to your monthly inflows, that additional $50 can become quite a burden. It does not take too much imagination to recognize the impact even greater debt payments can make.
The advice above applies during the pre-retirement as well as retirement period. Remember, too, during retirement most people do not earn a regular income. This means that any accrued debt must be repaid from available assets.
Uncontrolled use of credit can quickly reduce available assets. This may result in a significant reduction in monthly income. Keep this in mind as you consider credit use and debt accumulation. If you are in your pre-retirement period and anticipate significant expenditures during retirement, include that as you plan for retirement income funding. Doing this will reduce or eliminate the need to rely too much on credit use.