Buying more than you can afford because it seems 'free' or provides tax exemptions is a classic debt trap.
When the Mehtas saw an advertisement on television about a new hi-tech computer available with 0% down payment and 0% interest instalments, it seemed too tempting an opportunity to pass up. They almost went through with the transaction, until the local appliance shop owner welcomed them with a big smile and asked, “What can I do for you today?”
The statement was innocuous in itself and was the owner’s stock phrase used on every customer who walked in.
However, the Mehtas realised that they had heard the same phrase from the same person many, many times during the past few months.
Realisation dawned that their appliance purchases had become so frequent that they were meeting the shop owner more frequently than most of their friends.
All of us are bombarded with such tempting offers through multiple platforms.
From messages and (unwanted) calls on our cell phones to emails in our inbox (instead of the spam folder), not to mention in print and the huge hoardings that we drive by.
The question is whether we can afford such ‘free’ offers or not? Or are we already mired or trapped in unmanageable debt?
Defining the difference
Technically, unmanageable debt refers to non-housing related debt in excess of 8% of a person’s gross income.
The figure often comes into play when calculating eligibility for loans, particularly in the housing category. When it comes to housing loans, your front-end ratio, which consists of the four components of your mortgage: payment principal, interest, taxes, insurance (often collectively referred to as PITI), should not exceed 28% of your gross income.
Your back-end ratio, also known as the debt-to-income ratio, should not exceed 36% of your gross income.
The difference between the two is where the 8% figure comes from, according to the investopedia tutorial on how to manage credit and debt.
Figure it out
To calculate your maximum monthly debt based on these numbers, multiply your gross income by 0.36 and then divide by 12.
For example, if you earn Rs 7 lakh per year, your maximum monthly debt expenses should not exceed Rs 21000, of which not more than Rs 16,325 should be dedicated to housing.
That gives you about Rs 4,675 a month to cover your car payment, personal loans, credit cards and all other forms of debt.
For those at the initial stage of their career who keep buying new things because there is no upfront cost, this really doesn’t provide much room to service debts.
Think it over
Travel, cell phones and computers are among the possessions everyone seems to have. Everyone wants to live ‘the good life,’ but the financial reality is that not everyone can afford them at a young age.
Instead, simple decisions, such as not spending more than you earn and learning to delay purchases until you can pay for them without getting into debt beyond a point where you get into dangerous territory, can ensure your financial status remains in order.
In most cases, the biggest challenge you face isn’t financial, but the need to curb your desire to spend.
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