Just because you can buy it, doesn't mean you should. That basic financial rule of thumb is especially true when you're shopping for a home or a car, says J.J. Montanaro, a CERTIFIED FINANCIAL PLANNER™ practitioner with USAA.
"Never rely on lenders or dealers to tell you how much you can afford," says Montanaro. "Even if the payments seem manageable, putting too much of your income into a house or car could mean you're neglecting other, more important, aspects of your long-term financial security."
To avoid getting in over your head, Montanaro suggests the following tips:
Look at the big picture. Consider how much you're spending on your car or house in relation to all of your other expenses and savings. Possibly, you don't have trouble making that big mortgage payment today. But, ask yourself: Is it causing me to make smaller contributions to my retirement fund? Would I be sunk if I lost my job?
Question your motives. How many square feet of living space does your family really need? And are you buying a new car because you need it, or because you really want a more luxurious vehicle?
Avoid long-term vehicle loans. Auto loans are a reasonable type of debt, but the longer the loan term, the more you pay in interest. Also, if you finance your car or truck for more than four years, you could find yourself owing more than the car is worth. That's bad because if you total the car or want to trade it in, the proceeds you get from insurance or the sale of the vehicle may not be enough to pay off the loan.
Go long-term with your mortgage. Even if your goal is to pay off your mortgage in 15 years, consider using a 30-year fixed mortgage.
By making the same payment that would have been required with a 15-year loan, a large part will go toward the loan principal, reducing the term of the loan. However, if your income takes a hit, you won't be locked into the larger payment. If all goes well, the mortgage should still be paid off years ahead of schedule.
How to Assess Your Debt Situation
A quick calculation can tell you if you're in too deep. Financial advisers recommend keeping your total debt payments under 36% of your pretax, or gross, income.
Find your total debt-to-income ratio.
- Total your monthly debt payments. Include your monthly house payment, car payment, student debt and credit cards.
- Take your annual salary before taxes, including bonuses, and divide by 12 to determine your pretax monthly income.
- Divide your monthly debt by your pretax monthly income.
What your ratio says
- Under 20%: You're in great shape.
- 20% to 36%: This is a good debt load for most people, and lenders still consider you creditworthy if your credit score and other criteria are in good shape.
- 37% to 43%: Your debt levels are a little high. This could affect your ability to handle financial setbacks.
- More than 43%: Your debt levels are higher than recommended.
Two More Helpful Calculations
Find your housing-to-income ratio.
- Add up your monthly housing expenses, including mortgage principal, interest, property taxes and homeowners insurance.
- If you rent, add up what you pay for rent and renters insurance.
- Divide that number by your pretax monthly income.
Ideally, you'll spend 20% of your income or less on housing. Consider 28% as the absolute maximum to stay out of trouble.
Find your auto-to-income ratio.
- Total your monthly auto expenses, including loan payment, gas and average maintenance costs (do not include insurance).
- Divide by your pretax monthly income.
If you're spending 10% or less of your pretax income to get around town, you're good. You shouldn't go much above that number.
Options to Ease Your Burden
If your debt is higher than recommended, consider these tactics:
Downsize. Consider trading down to a smaller home or car. You may find a smaller home easier to maintain and a less expensive car cheaper to fuel, insure and repair. Ultimately, the lower financial stress levels may outweigh the benefits of the bigger house or nicer car.
Reduce your rates. Contact your creditors to see if you can negotiate lower rates or transfer your credit debt to a lower-rate card. Read the fine print, as transfer fees can come with a hefty price tag.
Refinance. Are you taking advantage of today's low rates? If not, look into refinancing your home or auto loans. Tread carefully here: Closing costs on a home loan could add to your debt load instead of easing it, and extending the term on an auto loan could leave you owing more than the car is worth.