What is too much debt? Do I have too much debt? If such questions have frequently started to cross your mind, it is time to delve into some details of your personal finances.
Before you figure out how much is too much debt…
First off, forget how much debt and focus on what kind of debt!
Identifying and understanding the various types of debt that you carry is very important for you to understand the gravity of your debt situation. Not all debt are created equal. A mortgage is just not the same as credit card debt. They are poles apart.
With a mortgage, you have debt that makes you pay interest on a loan that helped you buy an appreciating asset. With a credit card, you are paying sky-high interest charges on assets (that you bought) that have probably lost all their value. Credit card debt is so tricky that we first thought we must provide some insight about it specifically, before getting into whether your total debt is too much debt.
Why you must be very wary of credit card debt?
While most debt instruments require you to make equal monthly installments, credit cards give you the freedom to make as little as 2% of the outstanding credit card debt as your monthly payment. This freedom to “self-manage” your debt is a very dangerous double edged sword.
On the one hand, you have the convenient option to pay off 100% of your credit card debt without paying a dime in interest costs, ever!. But, the downside is that you can get sloppy and only make the 2% or 3% minimum down payments, leading you to pay ridiculously high interest costs for a very long period of time.
If you use your credit card often, it is highly recommended that you figure out how exactly your credit card works. What is your APR%? What is your grace period? Why minimum payments are a bad idea? How your credit card charges you daily interest and not monthly interest?! You can read about such items here at this Money Looms post about what you should know about your credit card.
You must also be very careful about using your credit card to pay off your debt. Why would you want to pay off a loan that charges 5% APR with a credit card that charges you 15% APR. It makes no financial sense. Yet, thousands of people do it when they are short on cash. If you are short on cash, cut back on your lifestyle rather than fish out your credit card to pay for that next transaction.
The reason why we took the detour to get into detail about credit card debt is to help you figure out a monthly payment that will not just minimally pay off your credit card debt, but pay it off responsibly or even aggressively. Once you have a monthly figure in mind, you can go ahead and use it in the simple calculation below.
Your monthly debt repayment outflow and your income – The Correlation
Your debt repayment outflow is just the sum of all your debt payments in a month. If you were paying $1,100 for your mortgage, $480 on your car loan and $200 for your credit card (a figure that is hopefully not just your minimum payment), your monthly debt payments sum up to $1,780.
Now, you will also need your pre-tax monthly income. Let’s assume in this example that your pre-tax monthly income is $5,000.
What is your debt-to-income ratio?
The best way to determine how much is too much debt is to use debt to income ratios. Why use this ratio? Because lending organizations like mortgage lenders or banks that process loan instruments like car loans and student loans themselves use this ratio to determine if you are a safe candidate to receive further loans.
When banks use a ratio to analyze your solvency, you can assume that it is a good solvency measure that you can use on yourself. However, digest these ratios with a grain of salt. Why? Because banks generally like to give you more funds that you can comfortably repay? Find it hard to believe? Don’t be so surprised.
The whole 2008-2009 mortgage sub-prime debacle was caused by banks being too lenient to borrowers. Since then, regulators have made sure that money is not handed out freely. But still, you can assume that borrowing just $5,000 is better for your good even if a bank is willing to give you $7,000 instead. The bank knows you can stretch yourself to pay $7,000 when you can comfortably pay $5,000. But that $2,000 will most probably put you in the “too much debt” zone.
Now, coming back to our example, using the assumed numbers mentioned above, your debt to income ratio would simply be $2,685 / $5,000 = 35.6%. This is what is known as the back-end debt to income ratio. There is also a front end ratio that uses only your mortgage debt payment in the calculation. Your front end debt to income ratio would be $1,100 / $5,000 which works out to 22%.
Banks generally conclude that you are in good financial health if your back end debt to income ratio is less than 36% and your front end debt to income ratio is less than or equal to 28%,
In the example we used, the person’s debt to income ratios manage to stay just below the radar, especially when it comes to the back end ratio.
You must run these calculations for your particular financial standing. If you find your debt to income ratios higher than the limits typically used by banks (36% for back end and 22% for front end), you have probably taken on too much debt.
How much is too much for different types of debt?
We spoke earlier that mortgage is a good kind of debt. After all, it allows you to buy a 30 year appreciating asset in present dollar value terms. But then, there can be such a thing as too much mortgage debt as well.
The problem with taking on too much mortgage debt is that you will find that the large monthly payment will start eating into your savings, as you spend for other things to keep up your updated lifestyle. Higher heating costs, more maintenance costs for your home, added lifestyle expenses to pay for possibly a larger family, retirement savings, insurance costs, health care costs etc, etc. The list can go on and on. Generally speaking, you want better things in life when you think you should live in a nice, large and comfortable home.
Ideally, your mortgage debt is probably too much if you are writing more than 25% of your pre-tax income as your monthly mortgage check. If your ratio is well over that threshold, you can possibly look to refinance or maybe even take a bolder step to sell your large home and occupy a smaller home, to significantly reduce your mortgage payment. This is particularly ideal if you have a good amount of equity in your home and if your home’s value has appreciated well, since the time you began your mortgage.
If you don’t own and instead rent, you can still use the numbers mentioned above to figure out if you are paying too much rent. Since you are not building any equity when you rent, you can add about a 25% premium to your rent to then calculate your affordability.
Car loan debt
After credit cards, auto loans are the worst type of debt people take on, simply because they take on too much. America’s never ending thirst to drive a new or relatively new car means that the average American is paying more than $500 for a new car every month!
Even that figure however doesn’t provide a complete picture, scary as it might sound. What is really bothersome is that the average car buyer takes on 2, 3 or sometimes more auto loans in a lifetime, when they eventually get tired of their ride. This means thrice the loan repayments, all on assets that depreciate very quickly.
Ideally, an affordable car payment should not be more than 5% to 10% of income. So, for someone earning $75,000 a year, $470 is right about where affordable is.
Student loan debt
Student loan debt can be too much debt when said student makes less than the borrowed student loan amount in the first year of employment. Studying at Ivy League schools is a good investment because students generally go on to earn more than $100,000 a year, even if they spent that much on their education.
Where it gets bad is when students spend $150,000 on their education to land a job that pays $50,000 a year. That just simply makes their student loan a burden that will take a long time to go away. Even worse is being unemployed after finishing your education, with just large student loan payments to show for years of educating yourself.
Like car payments, repayment on student loans should also not take away more than 10% of your income.
We hope you now have an idea about when debt is just too much debt. If you feel you have a unique situation that doesn’t conform to the examples mentioned in this post, do drop us a comment and we will be more than happy to give you our opinion on whether or not you have taken on too much debt.