Do You Need A Debt Ceiling?

By Stephen D. Simpson, CFA | May 30, 2011 AAA

Talk of the U.S. debt ceiling is all the rage these days, as Congress and the Obama administration continue to wrangle over the budget and whether the Congress should raise the statutory limit once again. While the executive branch does have some options and loopholes to navigate around the limit in the short run, the reality is that the debt ceiling imposes very real restrictions on the operation of Congress and some fiscal restraints on the U.S. government. (Follow these five steps to manage debt without cutting up your credit cards. See How Much Debt Can You Handle?)

TUTORIAL: How To Manage Credit And Debt

If the U.S. debt ceiling serves a useful role in limiting how far the country's government can extend itself before answering to the people's representatives, it is worth wondering whether there is a role for something similar in personal finances. In other words, do you need your own debt ceiling?

Advantages of a Ceiling
If nothing else, a personal debt ceiling can help a person stay out of trouble and keep debt at a level that can be managed within a person's current income. To some extent almost every individual does operate with a debt ceiling - there is a limit to how much lenders will loan out. Unfortunately, the point where creditors like credit card companies will cut off a borrower is often well past that borrower's actual economic capacity to manage that debt. By imposing a stricter personal ceiling, it is possible to lower the risk of serious problems like bankruptcy tied to profligate spending.

A debt ceiling can also help control over-spending while encouraging savings and investment at an age-appropriate level. If a person operates with a strict ceiling on the amount of debt they can carry in any given month, it is much harder to whip out the plastic and buy unnecessary things. At the same time, that "extra" money can be sent straight into savings and investment accounts where it offers much less temptation to a potential over-spender.

Disadvantages
One of the biggest weaknesses of a personal debt ceiling is that it is entirely arbitrary. There is plenty of good advice out there about how people should not take on a level of debt where repayments would constitute more than 20-35% of after-tax income, but over-spenders have a dangerous habit of finding exceptions for themselves.

Along similar lines, there is no punishment mechanism (no "or else") standing behind a personal debt ceiling; if somebody wants to overspend and borrow money to do so (say via a credit card) there are no consequences to doing so. In that respect, it is no different than enforcing any other sort of personal discipline - there is no one to punish the wannabe dieter for sneaking a donut.

On the flip side, a debt ceiling can encourage people to spend up to that ceiling even if they do not need to spend that money. There is a big difference between "need to" and "can," and some people struggle not to spend money that they have already allocated to themselves - even if they do not need anything else. In this case, it is not unthinkable that someone could end up buying more car or more house than they really need (or want) simply because they can afford to buy it.

Oddly enough, a debt ceiling can also be too restrictive. Very few people will be in a position to pay for law school or an MBA on the basis of their present income or savings when such education is that usual next step in their career. Likewise, most people have to go into significant debt to buy their first house. There are a lot of valid debates now about whether people should go into debt to buy a house or buy an education.

Is a Debt Ceiling Right for You?
The tricky part about a personal debt ceiling is that it is almost always going to be needed most by the people least likely to be willing try it (and perhaps the least willing to discipline themselves into following it). Still, for those who have gotten themselves into trouble with debt in the past, it is a worthwhile strategy to try as a way of getting better control over finances.

There a few key considerations to keep in mind. First, the debt ceiling needs to be based on common sense; there is no point in setting a limit that is below what someone already owes. That said, a debt ceiling also needs to be set in such a way that it allows (if not encourages) the person to save and invest along the way. It is also important to incorporate some sort of reward mechanism; a person who struggles to maintain self-discipline needs to have a reward mechanism to reinforce the entire system, and that may take the form of a small spending indulgence.

It is also important to remember that a personal debt ceiling needs to change with time and adjust to circumstances. A high ceiling for a prospective lawyer or doctor is entirely appropriate (so long as that debt is limited to school fees and necessary living expenses), but an established professional does not "need" a high-end luxury sedan or membership at a golf course that costs more than many people make in a year. That should be a key component of any debt ceiling - debt taken on today should be justified on the basis of it putting the borrower in place to save and invest more in the future.

TUTORIAL: Budgeting Basics

The Bottom Line
If the U.S. debt ceiling has accomplished anything, it is forcing Congress to periodically face the ramifications of its past decisions and the economy's capacity to sustain similar policies. With the debates going on today, it seems as though Congress may finally be willing to accept that the policies of the past cannot continue unaltered and that it is time for some fiscal conservatism.

A personal debt ceiling can serve similar purposes. Not only can a debt ceiling keep someone from letting their borrowing get out of control, but it can also force a more reasoned thought process when considering major expenditures. Though not fool-proof and certainly limited by an individual's own self-discipline, personal debt ceilings are a worthwhile consideration in anybody's spending, savings and budgeting plans. (Find out why this particular piece of national financing gets so much attention from the media and investors. Check out Breaking Down The U.S. Budget Deficit.)

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