Budgeting Debt Repayment

by Gary Foreman


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Dear Dollar Stretcher,
They say rent should be a third of your salary, or something like that. How much should be allocated to credit card debt if you made the mistake of getting into debt? If I paid each credit card a little bit, I'd still owe about $400 a month. What should my income be to pay that much each month but still not be in trouble? For instance, if I only earned $1,200 a month, I couldn't be expected to pay rent, food, etc., and credit cards. However, if I was making $100,000 a year, $400 a month wouldn't seem like much. Is there a way to calculate this?
Linda

Approximately 1 in 3 of us have at least one credit card with a balance due. And with a new law that required higher minimums taking effect in 2006, more and more consumers are wrestling with their minimum payment. So Linda asks a good question. How much debt repayment can I fit into my budget? And, yes, she's right. Someone with a $100,000 annual income can afford more than the person who takes home $1,200 each month. So let's see if we can't come up with some debt repayment guidelines for Linda.

Most family budgets are dominated by three categories: housing, auto and food. Combined they typically take up 65 to 70% of the budget. That leaves 30 to 35% for everything else: insurance, clothing, medical, dental, entertainment and vacations, education, property taxes, savings, and debt repayment. Most of these categories will require between 3% and 7%, which will quickly consume the remaining portion of your income. Each family is a little different, but most families can commit about 5% of their paycheck to repaying debt without twisting their budget out of shape.

How does that work out in Linda's case? A monthly payment of $400 is 5% of $8,000. So Linda would need to be bringing home $8,000 after taxes to hold to this budget. I hope that she is making $96,000 a year, but there's a good chance that she's not. So she might need to make some adjustments.

Even if she is making that much money, it's still wise to pay down her credit card balance. That's because it is unlikely to stay at the current level. The reason is simple. Life happens. There will always be "unexpected" home and auto repair bills. Even with good medical insurance, the deductible on a broken arm can be significant. And taking a nice vacation is real tempting.

If Linda is struggling already, she probably doesn't have money saved for these "emergencies." So they'll go on her credit card. And, that will boost her balance. The new minimum will only go up a little bit, but the hill she's climbing just got a little steeper.

The sad part is that many people fall into credit card debt because they can't afford to completely pay for whatever they bought during the month. Trouble is that the interest they'll owe only makes the original purchase more expensive. So they'll pay even more for something that they couldn't afford in the first place.

So what can Linda do? Take aggressive steps to pay down her credit card balance. Beginning now. The biggest opportunities are where she spends the most: housing, auto and food. It may be time to move to a smaller home or apartment, or take in a roommate. Replace an expensive car with a cheaper one. Commit to eating at home until her debt is paid off.

Linda should also look for ways to make small contributions to her "debt repayment fund." It's time to consider dropping premium cable channels, mocha lattes and other non-essentials. You'd be surprised how quickly these items can add up to a sizeable amount. Not only will she be reducing debt, but also she'll feel better about taking steps to reach her goal.

Some of these may seem overly drastic, but they are meant to be drastic. Linda is heading for a financial wreck. Here's how it will unfold. "Unexpected" expenses will add to her balance and her monthly minimum. If her minimum payments begin to exceed 5% of her budget, she'll soon find herself unable to make the monthly payment.

Then things will snowball. Each month, she'll struggle to make all the minimum payments on time. One day a payment will be a little late. Her interest rates will go up on all of her cards. That'll increase her minimum payment. That, in turn, will make it almost impossible to cover the new minimums. Her credit rating will go down. She'll trigger a chain of events that will take up to ten years to correct.

Linda is wise to correct it now while she still has time. Some of the steps she'll need to take will be painful. But she'll be avoiding much more financial pain in the future.


Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

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