How Much Debt is Too Much

Too Much Debt On The Scale

Forget Mount McKinley at 20,320 feet. By far the highest peak in America is Debt Mountain and millions of American’s are making it taller every day.

How much of that debt can you afford to call your own?

To find the answer, you first need to know just what the mountain is made of.

There is secured debt like mortgages and automobile loans. They are backed by collateral (or security), so the lender can repossess your house or car if you default.

There is unsecured debt like credit cards and student loans, which are backed only by the borrower’s promise to pay. That can be very unsecure.

Secured debt has a better reputation because so much of it is in mortgages and your house generally increases in value. Those chrome-plated tire rims you just bought with a Visa card do not.

But shiny rims can’t automatically be lumped into the “bad debt” pile. When it comes to the question of how much debt is too much, there are as many answers as there are people.

There are formulas to help you figure it out, and we’ll get to those in a second. But the basic answer is it all depends on what you can afford.

Debt-to-Income Ratio

So, how much debt can you afford?

If you’re Bill Gates, you don’t worry about maxing out that $18,000 limit on your credit card. Unfortunately, most of us aren’t worth $90 billion. But whether you make $30,000 a year or $30,000 an hour, there is a standard formula lenders use to determine when debt can become a problem.

It’s called debt-to-income ratio (DTI) and the math is pretty simple: Recurring monthly debt ÷ gross monthly income = debt-to-income ratio. It is expressed as a percentage.

Your recurring monthly debt are things you must pay every month like mortgage (or rent); car payment; credit cards; student loans; auto loans and any other loans bills that are due every month.

Gross monthly income is how much you make every month before taxes, insurance, Social Security, etc. are taken out of your paycheck.

For example, say you pay $1,000 a month on your mortgage, $500 on your car loan; $1,000 on credit cards and $500 on student loans. So, you’re total recurring debt is $3,000 a month.

The first conclusion is that you drive a pretty nice car, but that’s not important to this discussion. What is important is your gross monthly income, which is $6,000. Now let’s do the math.

Recurring debt ($3,000) ÷ gross monthly income ($6,000) = 0.50 or 50%, which is not good.

If your DTI is higher than 43%, you’ll have a hard time getting a mortgage. Most lenders say a DTI of 36% is acceptable, but they want to loan you money so they’re willing to cut some slack.

Many financial advisors say a DTI higher than 20% means you are carrying too much debt. Other say 28% is acceptable. The truth is that while DTI is a handy formula, there is no single indicator that debt is going to ruin your financial health.

Though if Bill Gates is reading this and figures out his total DTI is more than $18 billion, he might want to give up HBO for a few months.

How Do You Compare?

Debt enjoyed a banner year in 2016. Americans racked up $460 billion to run the total U.S. household debt to $12.58 trillion.

For a little perspective, you’d need a stack of $1,000 bills 364 feet high to have $1 billion. To reach $1 trillion, that stack would have to be 63 miles high. So America’s debt is approximately a 793-mile-high stack of $1,000 bills.

Welcome to Debt Mountain.

Houses account for most of that. Americans held $8.48 trillion in mortgage debt at the end of 2016. That worked out to an average debt of $176,222 for households that carried a mortgage.

But again, that is secured debt. Just qualifying for a mortgage requires at least a minimal level of financial stability.

Credit cards are much easier to get and much easier to abuse.  There was $779 billion worth of it in 2016, which worked out to an average of $16,748 for households that use credit cards. They pay $1,292 just in interest charges per year. That’s like throwing 107 $1 bills into your fireplace every month and watching it burn.

The other big unsecured debt was student loans, which skyrocketed to $1.31 trillion in 2016. That worked out to $49,905 for households that have a student loan debt.

Other forms of unsecured debt like personal loans, medical bills and utility bills make up the rest of that 793-mile-high mountain.

Warning Signs

How do you when your little part of that mountain is too high? Besides the DTI, there are everyday red flags like making only minimum payments on your credit card.

A few other signs that you’re getting in over your head:

  • When your debt payments are more than your mortgage payment.
  • Maxing out your credit cards.
  • Paying off one credit card with another.
  • Having you credit score decrease.
  • Getting turned down for a mortgage. Or worse, getting turned down for a credit card.
  • When you don’t have enough money to fund a $1,000 emergency fund.
  • When you begin getting phone calls from debt collection agencies.
  • When your relatives discreetly avoid you at family reunions.
  • When you start asking for advances on your paychecks.
  • When you start living paycheck to paycheck.
  • When you need payday loans to pay utilities or rent.
  • When your net worth is less than zero.

After all, nobody wants to feel worthless.

How to Deal with Debt

Between the warning signs and the DTI, hopefully you’ll come up an answer to the question of how much debt is too much debt for you.

If your DTI is below 20% and no red warning flags are waving, congratulations! But if you determine your debt is too much, it raises an even more important question:

What are you going to do about it?

The simple solution is to make more money, cut expenses or both.

No problem, right?

It takes dedication and a display of personal responsibility, but it also takes a plan.

Write down all your expenses and see where you can cut back. The devilish thing about unsecured debt is that the less you pay on those bills each month, the more you’ll eventually pay in interest charges.

One way to combat that is to get the lowest interest rate possible. A lot of consumers have turned to debt management programs, where a credit counselor helps you consolidate your debt and works with lenders to lower interest rates on credit cards.

Instead of paying all those separate bills, they are combined into one monthly payment that is lower than what you were previously shelling out.

The counselor also helps you design a budget that with expenses you can afford and simultaneously helps get rid of your debt.

The Great American Debt Mountain isn’t getting any smaller, but there’s no law saying you have to help it grow.


Sources:

NA)(2017, March 3). What is a debt-to-income ratio? Why is the 43% debt-to-income ratio so important? Retrieved from https://www.nerdwallet.com/blog/average-credit-card-debt-household/

(NA)(ND) Household Debt and Credit Report (Q1 20170. Retrieved from https://www.newyorkfed.org/microeconomics/hhdc.html

El Issa, E. ND, 2015 American Household Credit Card Debt Study. Retrieved from http://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/

(2015, September 29) Debt-to-Income Ratios. Retrieved from https://www.fanniemae.com/content/guide/selling/b3/6/02.html

Bright, Thomas. (2014, May 20) What is a good debt-to-income ratio, anyway? Retrieved from http://www.clearpointcreditcounselingsolutions.org/what-is-a-good-debt-to-income-ratio-anyway

Wiles, Russ. (2014, August 17) 7 warning signs you’re heading toward bankruptcy. Retrieved from http://www.azcentral.com/story/money/business/2014/08/04/7-warning-signs-youre-heading-toward-bankruptcy/13583821/

(2013, December 30) What is a debt-to-income ratio? Why is the 43% debt-to-income ratio important? Retrieved from http://www.consumerfinance.gov/askcfpb/1791/what-debt-income-ratio-why-43-debt-income-ratio-important.html