You will agree that managing your liabilities is just as important as managing your investments. This week we discuss how you can avoid taking on more debt than you can comfortably manage. Specifically, we discuss measures that you should take before assuming large liabilities to moderate the stress such repayments can have on your cash flows.

Debt trap?

The largest liability during your working life is the mortgage on your dream house. Typically, this repayment will constitute 40 per cent of your monthly income. Your mortgage liability could increase over time if the general interest rate in the economy increases. This is because banks will typically offer you a floating rate loan on the amount borrowed.

Now, paying 40 per cent of your income every month to meet your liability gives you limited flexibility to improve your current lifestyle and also save for the future. This issue is important, especially if your family has two incomes. Why? A typical two-income family has more expenses than a comparable single-income family. By this we mean that a two-income family that has 4 members will typically have higher monthly expenses than a single-income family with 4 members. Moreover, a two-income family may take on a higher mortgage because it can afford to do so.

Higher liability and more lavish lifestyle may be a cause for concern, especially if there is threat of losing one income. This could happen due to various reasons including family circumstances and bad economic conditions. So, how should you moderate the stress of having to repay your liabilities when your family income reduces?

Stress-testing liability

If your family has two incomes, try to manage your monthly expenses including your liability repayments with single (higher) income! You can save the entire second income and build wealth for future consumption. The accumulated wealth can also be used to pay for liabilities if there is a loss of one income.

We realise that is easier said than done. After all, with two incomes comes the associated lifestyle and higher living expenses.

A more realistic alternative would be to manage your monthly living expenses including mortgage repayments with the higher income and not more than 50 per cent of the second income. Let us define this cash flow as the “available income” for monthly spending. If your family has single income, try to manage all your debt repayments within 40 per cent of your monthly income.

You should stress-test your available income before you assume a large liability.

This provides you a reality-check on whether you can sustain the liability repayments with minimal stress.

To do this, deposit the intended monthly repayments from your available income into a separate savings account for six months before you actually assume the liability. If you are able to comfortably make the deposits, you should assume the liability. Otherwise, consider scaling down your debt.

Emergency fund

It is important to stress-test your cash flow before you assume large liabilities. You should also include monthly debt repayments as part of your emergency fund.

If your family has two incomes, the emergency fund can be 6 times your monthly living expenses including the debt repayments. This multiplier can be 8 if your family has single income.

And remember this: you should control your non-discretionary expenses during normal times! Why?

During times of stress, you will have to anyway give up your discretionary expenses such as occasional fine dining and exotic vacations. So, when will you enjoy life’s luxuries? Importantly, do not sharply cut your discretionary expenses to buy a house that you cannot otherwise afford.

If it is a choice between occasional luxury and a larger house, choose luxury to enjoy life and reduce the stress on your cash flow.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in)

(This article was published on March 9, 2013)
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