Managing Your Money to Keep The Debt Monkey Off Your Back

When it comes to borrowing money, caution is coming into vogue.
By: Jaclyne Badal: The Wall Street Journal Online
Financial advisers have long warned people against taking on too much debt. But as debt loads for companies and individuals climb, a growing number of people - from regulators and Wall Street analysts to home lenders and economists - are picking up the cry.

This growing fondness for moderation is fueled by a multifaceted expansion in borrowing:

• Climbing housing debt, along with a sharp increase in delinquencies and foreclosures.

• Record levels of margin debt, or money borrowed to buy stocks.

• Government figures showing that consumers for the past two years have spent more than they made, something that hadn't happened since the Great Depression.

As a growing number of people get swept up in the borrowing binge, this is a good time to assess your finances and determine how much debt is too much.

Paying with Plastic

Take credit-card debt, which is usually the most expensive (as far as interest rates) and also the easiest to obtain. Consumers often think about their credit-card debt in terms of the minimum monthly payment, and glaze over the balance outstanding. That's a big mistake, says Nigel Taylor, a financial planner in Santa Monica, Calif., because it allows people to underestimate their debt load while balances creep up to unmanageable levels.

Data from Equifax and Moody's Economy.com show credit-card balances in the U.S. at a record $746.74 billion as of March - up 18% from five years earlier.

A good exercise is to periodically tally the balances on all your consumer debt, like credit cards and car loans (but not home loans). Divide the total by your annual gross income. You want that figure below 30%, according to a common rule of thumb.

People on the high side don't need to panic, but they should do some soul searching to determine why they borrow so much and whether they're comfortable with those amounts.

Consumers who take on too much credit-card debt run the risk of hurting their credit scores, which makes it more expensive to borrow money in the future. And they can potentially wind up in bankruptcy proceedings, a process that's more painful and has more rules than it did a few years ago.

On the House

Mortgage lenders have tightened standards recently. But consumers still have the potential to get approved for a bigger home loan than they can afford.

A general rule of thumb is that no more than 28% of gross monthly income should go toward house-related debt (including taxes and insurance). Besides first mortgages, this includes home-equity loans, which allow people to take out a lump-sum loan against the house, and home-equity lines of credit, which allow people to borrow against the house over time, taking out money when needed.

A person who makes $5,000 a month before taxes, for example, wouldn't want the monthly bill for house debt to exceed $1,400.

Note that the 28% guideline has a caveat: Monthly debt payments for everything - house, credit cards, car loans, student loans, etc. - shouldn't be above 36% of gross monthly income. So if you spend 28% of your monthly pay on house debt, you have only 8% left for the remainder of your debt payments. In the example of someone who earns $5,000 a month, 8% would come to $400. Many car payments are more than that.

And those percentages - frequently called debt-to-income ratios - are maximums, not recommendations for healthy living. People who spend 36% of their pay on debt are "teetering on the edge of being financially unstable," says June Walbert, a financial planner with San Antonio-based USAA, a financial-services company that largely focuses on military families.

She counsels clients to limit total debt payments to 20% of pretax income, so they have a buffer for surprise expenses.

One way to keep from getting in too deep is to run a worst-case scenario before taking out any money. Home-equity lines of credit, for instance, often come with variable interest rates, but banks are required to disclose a rate cap in the loan documents. Calculate what the payment would be if you borrowed up to the limit at the highest interest rate.

Financing Stocks

While most people stick to consumer and house debt, a growing number of investors also are borrowing money from brokerage firms to buy stocks or other securities.

Such margin debt for individual investors hit a record $295.87 billion in February, according to NYSE Euronext data. Before this year, the record was $278.53 billion, set in March 2000 near the peak of the high-tech bubble.

Buying stocks on margin magnifies price gains, but also losses. The National Association of Securities Dealers, which regulates securities firms, warned last month that "many investors may underestimate the risks of trading on margin."

Margin debt is regulated by strict rules from the Federal Reserve, the NASD and the NYSE. Investors can't borrow more than 50% of the price of the stock. And their equity in the account can't fall below 25%.

Confused? Let's say a person finances 50% of a $25,000 stock purchase, and the market crashes immediately afterward, so the stock is worth only $15,000. Since the investor still owes the brokerage $12,500, his equity in the account is now only $2,500, or 16.7% of the stock's value - below the 25% maintenance margin requirement.

At that point, the investor would face a "margin call." He would need to deposit another $1,250 immediately or the brokerage would have to sell $5,000 of stock. (That would reduce the debt to $7,500 or 75% of the remaining $10,000 stock position.)

The NASD notes that the firm can sell securities without contacting the investor and can set its own "house" limits on margin, which can be bumped up at any time. (For more, go to nasd.com and click on "Investor Alerts" on the right side.)

Investors can get pummeled using margin debt and, unlike with other types of debt, the situation can implode in a matter of days or even hours. "Generally, I don't think it's worth the risk," says Steve Margulin, a financial planner in Albuquerque, N.M.

Before investing on margin, it's a good idea to understand the worst-case scenario. Ask yourself if you're comfortable losing much of what you deposited and borrowed, plus interest and fees. If not, consider backing off.