Most budgeting articles tell you that debt is akin to death and credit cards are cancer. Sure, cutting debt out of your life completely is solid advice, but often it's a bit like telling a drowning man that water is bad for his lungs. (For background reading, check out 7 Tips For The Do-It-Yourself Debt Manager.)

America has become the land of the free-to-charge. Debt is a fact of life for millions of U.S citizens. In this article we'll teach you to swim and help you create a disciplined system for monitoring personal debt. Specifically, this will help you define your "personal debt redline" - the point at which you should begin to think twice before charging up more debt. Monitoring your total debt load against this line can become a useful discipline for developing effective budgeting and spending habits for life. This system recognizes that many people use debt productively to maintain their lifestyles and achieve personal goals. It's also simpler than many others, consisting of five steps.

Tutorial: Credit And Debt Management

Easy-Credit Nation
Imagine yourself walking to the front of the checkout line in a store. You reach for a credit card to swipe. As your card glides through the scanner, a red light flashes and a buzzer blares. "There must be some mistake!" you cry out. "I'm not over my limit." Looking at you with deep concern, the cashier says, "True, but you are dangerously close to having too much credit in your LIFE! Maybe you should go easy on the charges for a while."

Dare to dream. It would be great if life came with warnings like this, but unfortunately this scenario does not reflect the world of today. If one of your cards hits its credit limit - well, that's why wallets are made to hold several, right?

Between 2005 and 2008, total U.S. revolving debt (the kind you rack up on your credit cards and lines of credit), inched upward each year before hitting a high of $957.5 billion in 2008. In 2009, it fell to $865 billion, and continued to fall through 2010, according to the Federal Reserve. But those years represented tough times in the U.S., and it is likely that when the economy improves and employment creeps back up again, debt loads will soon follow. After all, no other nation in history has become so indebted so fast, especially during times of relative prosperity. (To learn more, read Stop Keeping Up With The Joneses - They're Broke and The Disposable Society: An Expensive Place To Live.)

In this easy-credit environment, some people intuitively have felt their personal debt start to spin out of control. But without a warning system, how can you know for sure that you have crossed the line? Follow these fives steps to define your line.

Step No.1 - Focus on your discretionary spending and debt
"Discretionary" means you have some control over what you charge or borrow. Practically speaking, this means that, in this process, you can set aside debts over which you have little short-term control, such as home mortgages, car loans or leases. Those are important, but there may not be much you can do to manage them in the short-term. In this process, we will focus on credit/debt that you can avoid or adjust, if necessary. (For tips on dealing with mortgage debt, see Mortgages: The ABCs Of Refinancing.)

Step No.2 - Recognize that your debt should be in proportion to three important financial resources
Unless you are retired, you have three ways of building assets and/or repaying debts:

  1. Your savings, investments and "rainy-day" liquidity
  2. Your job security and prospects for income growth
  3. Your discretionary income, after necessary expenses

If you are fully retired or otherwise not working, you won't be able to count on the second item above.

"Rainy-day" liquidity is money you could tap quickly and easily to tide you through a difficult period. Some financial advisors recommend having at least three to six months' worth of your average total monthly household expenses in such an emergency fund. (For more on creating this life saver, see Build Yourself An Emergency Fund.)

The first two points above are somewhat subjective, and household circumstances vary. For example, many younger households have not had time to build savings and investments - but they still have time on their side. Job security and prospects for income growth are often uncertain, so your attitude and confidence may be as important as objective facts or data. It may be useful to work with a professional financial advisor to evaluate the specific progress you are making in these three areas.

Step No.3 - Rate your current situation in regard to the first two resources
First, you have to give yourself a progress rating. To do this, use a scale of 1-5, in which 1 = low progress and/or confidence and 5 = high progress and/or confidence. (Select the number in the table below that best applies.)

Rate your progress and confidence in…
…your savings, investments and "rainy-day" liquidity.
…job security and income growth prospects.
Total of the two
scores above.


1. You feel that your savings, investments and "rainy-day" liquidity are about average - you rate this 3.
2. You feel that your job security and prospects for income growth are above average - you rate this 4.

Now add these two scores together. In the above example, the total is 7. Hold your measurement until Step 5.

Step No.4 - Determine the discretionary income you can allocate to debt repayment
Sit down with a typical month's worth of income and spending data and determine the third financial resource - discretionary income. This is calculated by taking your total month's income and subtracting your expenses. For this purpose, do not count current debt payments (except for mortgage and auto) in the expenses. For example, do not count amounts that you send to credit card companies or repay on consumer loans. However, do count all necessary living expenses, such as for rent/mortgage, food, clothing, utilities, education, etc. Also, count any repayments made for debit cards, as these represent current expenses, not credit.

Suppose you have total monthly income of $5,000 and you determine that your necessary monthly expenses total $3,500. In that case, you have $1,500 of discretionary income that may be used for:
  1. Savings or investment;
  2. Discretionary expenses, such as home improvements, entertainment or vacations.
  3. Repaying principal and interest on your outstanding credit.

Some households carry little or no debt on their homes or cars. This system recognizes their potential to increase other types of credit comfortably, because they often have relatively higher amounts of discretionary income.

Step No.5 - Estimate Your Personal Debt Redline
Using the total score from Step No.3, the guideline percentages in the table below will help to estimate the maximum portion of your monthly discretionary income that you should plan to allocate to repaying debts (principal + interest). By tracking the monthly amounts you actually pay for all debts (excluding home or car), you can then determine if you have exceeded your personal debt redline, and make any necessary adjustments.

Guideline Percentages for Debt Repayment Total Score from Step No.3
2 3-4 5-6 7-8 9-10
Maximum portion of monthly discretionary income you should allocate to debt repayment (principal + interest) 10% 15% 20% 30% 40%

Your total score in Step No.3 was 7. Your monthly discretionary income in Step No.4 was $1,500.

The table estimates that you will hit your debt redline when you are spending more than about 30% of your discretionary income to debt repayment. You should try to keep your monthly debt repayments below about $500 per month ($1,500 x 30%).

On revolving credit, such as credit cards, you should generally estimate your monthly debt repayments based on making somewhat more than the minimum required payments. This is because, by paying only the minimum, you may not escape debt in your lifetime. (To learn the mechanics of how this works, see Understanding Credit Card Interest.)

The Redline Can Move
While this exercise is somewhat subjective, it can help you realize two important points:

  1. When you have a disciplined way of monitoring debt repayment obligations, it's harder to slide gradually into a situation where you are in over your head.
  2. Your ability to carry debt depends on your progress and confidence at work and in building your savings, investments and rainy-day liquidity.

Your debt redline may change over time. For example, if you learn that your company will be handing out pink slips in the near future, it may be a time to start cutting back on charges. Conversely, if your job prospects brighten or you make steady progress building financial assets, you can be comfortable carrying more debt. Since the redline is defined in debt repayment dollars (not total debt outstanding), it will remind you to cut back on charges if interest rates rise and increase the cost of debt repayment obligations.

If you are married, it's a good idea for both spouses to separately evaluate the subjective questions in Step No.3. Any differences in your thinking should be discussed and resolved. While it's not essential to monitor discretionary income (after necessary expenses) for more than a couple of months, you may find that this is a valuable budgeting discipline that you will want to continue.

The Bottom Line
Most debt management systems are like diets. They tell you what you can't do. This one is different because it begins by asking you to define your financial success and confidence. Taking charge of your debts now can be the key to maintaining good credit and strong financial progress for years to come. Know where your personal debt redline is - and do your best to walk the line.

If you find that you are already spending too much on debt repayment, see Digging Out Of Personal Debt.

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