Question: Setting your own debt limit - Debt payments-to-disposable income method To prevent your level of debt from getting out of control, you should determine your
Setting your own debt limit - Debt payments-to-disposable income method
To prevent your level of debt from getting out of control, you should determine your debt limit. A debt limit is the overall maximum amount of debt you should owe based on your ability to meet the repayment obligations.
One strategy for determining your debt limit is the debt payments-to-disposable income method, which involves deciding on the percentage of your disposable income (the amount of income remaining after taxes, insurance, mortgage payments, and so on) that can be spent for regular debt repayments. Once you decide on a percentage that is appropriate for you, you can compare that percentage with your debt payments-to-disposable income ratio, which is the ratio between monthly nonmortgage debt repayments and your monthly disposable income.
You can use the following equation to calculate your debt payments-to-disposable income ratio:
| Debt payments-to-disposable income ratio Debt payments-to-disposable income ratio | = = | Monthly nonmortgage debt repayments Monthly disposable income Monthly nonmortgage debt repayments Monthly disposable income |
You should strive to maintain a debt payments-to-disposable income ratio of 15% or less.
Suppose that Tracy has a gross annual income of $38,000. Her annual deductions for taxes, 401(k) retirement plan contributions, and health insurance amount to $8,600. This leaves Tracy with an annual disposable income of $29,400. Dividing Tracys annual disposable income by 12, you can determine that Tracy has a monthly disposable income of $
.
This is Tracys budget for her monthly disposable income:
| Tracys Monthly Budget | |
|---|---|
| Rent | $750 |
| Savings and investments | $50 |
| Food | $200 |
| Utilities | $65 |
| Insurance | $61 |
| Transportation expenses | $115 |
| Charitable contributions | $25 |
| Entertainment | $100 |
| Clothing | $45 |
| Vacations and long weekends | $30 |
| Medical/dental expenses | $90 |
| Newspapers and magazines | $40 |
| Cable TV | $75 |
| Personal care | $75 |
| Gifts and holidays | $45 |
| Health club membership | $50 |
| Miscellaneous expenses | $95 |
| Debt repayments | $539 |
What is Tracys debt payments-to-disposable income ratio? Round your answer to nearest whole number.
| Total monthly debt repayments Monthly disposable income Total monthly debt repayments Monthly disposable income | = = |
| / / |
| = = |
|
Tracys debt payments-to-disposable income ratio is higher than the recommended debt limit of 15%
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