The other day I came across the following article, Debt and Credit: Known Your Limits, which has a guideline in it stating that consumer debt (“non-mortgage obligations such as credit cards, auto loans and installment plans”) should not be more than 20% of your net take home pay. I’m sorry, but that strikes me as a really bad idea and it might be due to the fact that I subscribe to the same school of thought as what Dave Ramsey presents in The Total Money Makeover: A Proven Plan for Financial Fitness and what Mr. Money Mustache advocates when he says that your debt is an emergency.
If we use $45,000 as the average household income in the United States and a very rough estimate of 35% of the gross being taken to cover taxes, heath insurance, retirement, and so forth we arrive at a net income of about $29,250. On a monthly basis that is about $2,625 and if we were to follow the “advice” that up 20% of your net income can be consumer debt then that means that monthly payments up to $487.50 would be considered “acceptable.” That’s a horrible idea since it leads to people thinking that because their monthly credit card payments haven’t yet reached that 20% figure that getting more debt is acceptable. However, if we use a minimum payment calculator, a $525 monthly credit card payment works out to carrying a balance of $19,500 at 18% interest. That means that if you make the minimum payment you will end up paying $28,675.23 in interest over 408 months! So somebody please explain to me how that is a good idea?
Now, I suppose that the author of the article might have car payments in mind when they came up with that figure as opposed credit card debt in which case the figure might make nominally more sense; however, on the same token, do you really need a car that costs $525 a month just to cover the payment? Using the previous examples, Mr. Money Mustache is a pretty strong advocate of not even owning a “clown car” in the first place where as Dave Ramsey advocates for selling any vehicles that you have when you are in debt and paying cash for a “clunker” that will get your to and from work each day. Two extremes, but I can see where they are coming from and myself personally, I’d rather not have the car payment.
Now I tried to do some searching around to see if this advice was echoed elsewhere and baring some interesting articles in the New York Times about consumer debt (e.g. “How Much Debt Should Households Have?“, “Crisis Prompts a Rush Back to the Mortgage Basics“) I really couldn’t find much. The article that I found in Time on “Consumer Debt: How Do You Compare?” seems to be quite representative of most of them in that it notes that the debt loads tend to be uneven but it states that the average household debt in 2011 was 11.5% of after-tax disposable income but on the same token, that figure also includes mortgages so is largely useless as a metric of consumer debt.
At the end of the day though, no, 20% of your net income should not be servicing consumer debt. You might be able to make a case for a car payment if you can’t afford to pay cash for a car (you can’t use this excuse as you get older though) but Saturday Nightly Live had a skit that perfectly sum my position on credit cards: