When you’re drowning in debt, it’s difficult to get out from under. So play it safe before you get to the point where you’re missing mortgage payments, borrowing from Tom to pay off Dick, or struggling to pay even the minimum on your credit cards. Here are a few rules of thumb to help prevent debt problems.
Set aside 10 percent of your income for savingsMany smart investors and comfortable retirees have one thing in common -- they invest or save at least 10 percent of their after-tax income. Skim that money right off the top of your paycheck, directly depositing it into savings, if possible. After the first few months, you’ll get used to living without it. Invest this money in savings for a home, your children’s college education, an emergency fund, your IRA or another savings vehicle.
Maintain rent or house expenses at 30 percent of your incomeIf your rent expenses go higher than 30 percent of your income, you might not be able to afford the down payment on a house. If you do own a house, 30 percent of your income is still a good goal for mortgage and other house expenses such as utilities. This should allow you enough money for priorities such as food, clothing, transportation and other needs.
Keep living expenses at no more than a quarter of your incomeThis includes food, clothing, entertainment and holidays.
Aim for manageable numbers when you buy a houseYour home shouldn’t cost more than two-and-a-half times your gross income. And to ensure you’re not carrying an unmanageable mortgage, your down payment on a house should cover at least 20 percent of its cost. In other words, if you earn $50,000 a year, you should be able to afford to buy a $125,000 house (that’s two-and-a-half times $50,000). Aim to save 20 percent of the purchase price, or $25,000, for a down payment if you can afford to.
Transportation should be no more than 15 percent of your incomeThis includes car payments, gas, maintenance costs, tolls, parking, insurance, buses, taxis and commuter trains.
Shoot below 30 percent of your income for debtsIf you own a house, this includes your mortgage costs. If you’re a homeowner paying close to 20 percent of your income on your mortgage, your credit card debts and other loans should comprise only 10 percent of your income -- at the very most. If your long-term debt load is more than 30 percent of your income, consider a debt consolidation loan to make your monthly payments more manageable.
Life insurance can range from five to 10 times your salaryEven generous employers can offer policies that cover only twice your salary. If you have a high debt load and are also married with children, you may need to protect your family with the upper end of this range. Exactly how much depends on many factors, such as the size of your mortgage, your children’s future needs and your other requirements.
Set aside three or six months’ income for emergenciesThis will protect you from having to draw from your cash flow in the event of a crisis.
Keep in mind that these are helpful rules of thumb to provide you with guidance for the long run. But your circumstances may prevent you from "playing by the rules" in the short term. If you live in New York, for instance, you may have no choice but to overspend on accommodation. If you live in Alaska, your transportation costs to visit your ailing mother in Ohio may be high. Whatever your circumstances, if you have to spend high in one area, make cuts elsewhere.