Can I Afford This? A No-Fail Formula

By Markets Fool.com

If there's one thing Americans love, it's instant gratification. Whether it's a new watch, phone, or laptop, many of us have little motivation to save for the things we want when it's easier (and far more satisfying) to whip out our credit cards and charge our way through life. It's for this reason that credit card debt is a huge problem for spenders across all ages and income levels.

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The average American household has an estimated $5,700 in credit card debt. Borrowers ages 45 to 54 appear to have the most credit card debt, with an average of just over $9,000. Meanwhile, those under 35 and over 75 have the least amount of debt. Debt levels among Americans also seem to grow proportionately with income. Those earning between $25,000 and $44,999 have $3,900 on average in credit card debt. Those earning between $70,000 and $114,999, however, have $5,800. And those earning $160,000 or more have a whopping $11,200. All of this data tells us one thing: Americans as a whole aren't doing a very good job of only buying what they can afford.

The dangers of credit card debt

Carrying a credit card balance means throwing away money on interest charges right off the bat. And the longer it takes you to pay off a balance, the more you stand to lose.

Let's say you rack up $4,000 in credit card debt, and that it takes you two years to pay off that balance. At 14% interest, you've just thrown away over $600. Now imagine it takes you an extra year to pay off that sum. Guess what? You just lost over $900 in interest fees.

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But there's another problem with credit card debt. The more you take advantage of your credit line, the more you risk lowering your credit score, and when that happens, borrowing becomes even more expensive. It's important to keep your credit utilization ratio--the percentage of available credit you're using -- to 30% or lower. This means that if you have a total credit line of $10,000, you shouldn't carry a balance higher than $3,000, as doing so could negatively impact your credit. Unfortunately, many of us don't follow this rule.

Avoiding credit card debt

Avoiding credit card debt takes discipline, but it's also a matter of numbers. We're often wired to assume that we can afford things that don't seem that expensive, when in reality, "expensive" is a relative term. So here's an easy way to figure out if you can really afford something -- whatever that something might be. If your monthly earnings are enough to cover your fixed living expenses plus your desired purchase without having to use a credit card to make up the difference, then the answer is yes, you can afford the item in question. If the answer is no, then you can't afford whatever it is you're hoping to buy -- and you shouldn't buy it.

This basic equation goes as follows:

Monthly earnings fixed monthly living expenses = money available for whatever it is you want

It's that simple.

Now this formula assumes that you don't have any savings to tap -- which many Americans don't. It also assumes that any savings you have should be left untouched and reserved for emergencies only. Furthermore, this formula won't actually help you save any money; its sole purpose is to keep you out of debt.

Say you bring home $3,000 a month and your fixed living costs total $2,000. If you're looking to buy a $900 television, you're good to go because you're only spending $2,900 of your available $3,000.

Now let's say you bring home $4,500 a month, your fixed living expenses equal $4,200 a month, and you have your eye on a $400 tablet. Because that $400 exceeds your available $300, you should pass until you've saved the extra money.

The great thing about this formula is that it will tell you whether you can afford something regardless of your earnings or the cost of the item at hand. As we saw in our example, and in our real-world credit card data, earning more money doesn't necessarily put you in a better position to pay for something than someone with less income. Similarly, just because one item costs more than another doesn't mean it's not affordable, because cost is only one variable to consider. It could very well be that one person can afford a $2,000 computer while another can't swing a $30 shirt.

Whether or not you can afford something is a matter of your own income and expenses, and the things your friends and neighbors can or can't afford should have no impact on your spending decisions. Stick to the formula, ignore everyone else, and you'll stay out of debt. It really is that simple.

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