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 card debt 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.

Use our Do I Have Too Much Debt Calculator for a breakdown of what percent of your monthly income is going to credit card debt and mortgage, and how much is left as disposable income to pay your other bills.

Do I Have Too Much Debt Calculator

What percent of your monthly income is going to your debt payments? Use the calculator below and get an analysis on whether or not you have too much debt. If your combined mortgage and consumer debt payments exceed 45 percent of your take-home pay, you may want to consider working with a credit card consolidation company to lower your monthly payments.

How Does Your Debt 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.

Auto Debt: How to Tell If You Have Too Much?

If you haven’t shopped for a car in while, get ready for sticker shock. The average U.S. new-vehicle transaction price was $34,077 in December of 2016, according to Edmunds.com.

That was an all-time high and nobody expects the upward trend to stop. On average, consumers are paying $495 a month for new car loans, according to Experian. That’s almost $50 a month more than the 2008 average.

With prices so high, the once-traditional 48-month payment plan has been stretched to 72 and even 84 months. Lower monthly payments make cars more affordable, but you could end up owing more money than the vehicle is worth. And remember, a new car drops about 11% in value the minute it’s driven out of the dealer’s lot.

A sign your auto loan is too high

You need more than a 60-month loan to pay off the car and you can’t afford a 20% down payment. Try to keep your monthly payments below 10% of your gross monthly income.

What to do when you have too much auto debt

Sell the car, even if you get slightly less than it’s worth. Then put that money toward a car you can afford.

Refinance your loan. You could find a lower interest rate, but this is more a Band-Aid than a cure.

Consider alternative means of getting around, like carpooling, public transportation, Uber and even a bicycle.

Mortgage Debt: How Much is Too Much?

Speaking of rising prices, the median price of a house in the U.S. was $18,000 in 1963. It was an all-time high of $263,800 in June of 2017, according to Zillow.

Rising prices are good news if you already own one. But the housing market can collapse, as millions Americans discovered the hard way in the Great Recession.

A sign you owe too much on your home

The house you’re considering buying costs more than 2.5 times your annual income. For instance, if you make $60,000 a year, avoid any house that cost more than $150,000.

Whatever the sale price, your monthly payment should not exceed 25% of your gross monthly income.

A 20% down payment is highly recommended, since it could save you thousands of dollars in private mortgage insurance (PMI).  A 15-year mortgage is also preferable to a 30-year, since you’ll save tens of thousands of dollars in interest.

How to deal with too much mortgage debt

Refinance to a lower interest rate. The saving could be enough to make the mortgage manageable.

You could also refinance to a longer payment period. Going from a 15-year to a 30-year mortgage will appreciably cut your monthly payments. The down side is you’ll end up paying a ton more in interest over the life of the loan.

Your best option might well be to sell the house. Downsize into something that fits your budget. Consider renting, since you can usually rent a house in the same neighborhood for less than you’re paying on your mortgage.

You won’t build any equity, but renting gives you much more flexibility if financial challenges arise.

Student Loan Debt: Have You Borrowed Too Much?

If cars and houses give you sticker shock, you might need hospitalization if you get near a college campus.

The average annual tuition at public colleges was $9,139 for in-state residents and $22,958 for out-of-state residents in 2015, according to College Board. It was $31,231 at private colleges.

It’s pricier at top-notch schools. Stanford, which charged no tuition from its opening in 1891 until 1920, now cost $46,320 a year regardless of where the student is from.

From 1995-2015, tuition and fees at 310 national universities rose almost 180% at private schools and 225% at public schools, according to U.S. News & World Report. The total student debt tab of $1.3 trillion is shared by 42 million Americans, and it’s increasingly apparent a lot of them are in over their heads.

Millions had not made a payment on $137 billion in federal student loans for at least nine months in 2016, according to the Consumer Federation of America. The total defaults were 14% higher than 2015.

A sign you have too much student loan debt

You have borrowed more for your student loan than you will make in your first year’s salary. Also, your total debt should not exceed more than you can repay in 10 years.

The average student debt was $37,172 in 2016. With a 5.7% interest rate, you’d pay $407 a month for 10 years.

What to do when you have too much student loan debt?

Consolidate and refinance your loans to get a lower interest rate. The rates for federal loans typically range from 3.5% to 7%, but private loans can creep higher.

Federal interest rates are set by Congress and private student loans can’t be refinanced through a federal loan. You can, however, refinance them through private lending institutions.

Federal loans do offer income-driven repayment plans that are worth exploring. In those, monthly payment plans are based on your income.

The best plan is to shop around for colleges and careers before you shop around for loans. Many times you can get as much educational bang for your buck at schools charging half what top-rated universities charge.

Regardless of what you feel called to do with your life, factor a little financial pragmatism. The average starting salary for computer engineers is about $70,000, which the average for Liberal Arts majors is $40,000.

By all means, pursue your passion. Just remember, passion doesn’t pay the bills.

How Much Credit Card Debt is Too Much?

As oppressive as mortgage, car and student loan debt can be, at least they don’t leave you feeling like you’ve been flimflammed by a con man. Credit card debt should have that effect. The problem is, it often doesn’t.

The flimflam is the interest rates, which are three-to-four time higher than the other major debt components. It must be noted there are reasons credit card companies charge such rates.

First, they must protect themselves from getting burned by high-risk lending.

Second, they can. And that’s mainly because most people don’t do the math and see how interest rates silently turn those $120 sneakers into $149 lead weights.

How to tell you’ve borrowed to much

You are making only the minimum monthly payments. You cannot pay off your total credit card debt in one year.

You are using credit cards to pay for essentials like gas and food. You are using one card to pay off another card.

You are using balance transfers to get low introductory rates, which will expire and rocket back up. Your credit card payments are more than your mortgage.

How to deal with too much credit card debt

Ask for a lower interest rate. Many credit card companies will cut you a break, especially if you threaten to transfer the balance to a competing card with a lower rate.

Use cash. Peeling off six $20 bills for those sneakers is a lot harder than simply slapping down a piece of plastic and saying, “Charge it.”

Consolidate your cards. Instead of paying varying interest rates, find the lowest one and put all your debt on that one. The danger is the low introductory rate on transfers usually last about a year, then high interest rates kick in.

A better option is to consider a debt management program, where your bills are combined into one monthly payment that does not balloon after a year. A nonprofit credit counseling agency like InCharge Debt Solutions can help reduce the interest rate to 8% or less.

Warning Signs You have Too Much Debt

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:

You Are Frequently Charged Over-the-Limit Fees on Maxed-Out Your Credit Cards

Many credit cards charge fees for spending over your credit limit or maxing out your credit cards. This will make this month’s balance larger than last month’s. If all of your credit card balances are greater than 80 percent of your credit limits, consider this a danger signal.

You Cannot Pay off Your Credit Card Debt in One Year

As a general rule of thumb, you either have too many credit cards or you are carrying too much debt if it seems you cannot pay off your combined credit card debt within one year. When was the last time you had a zero balance on your credit cards?

Using Credit Cards to Pay for Essentials like Gas and Food Because You Are Out of Money

Many people are using credit for small purchases such as gas and food. If you previously paid cash for these or other small items, but are now using credit, it could be a sign that there’s a problem.

High Debt-to-Income Ratio

Your debt-to-income ratio measures the amount of debt you have against your income. You can calculate this ratio by dividing your total monthly debt payment (excluding mortgage/rent) by your total monthly gross income (before taxes). For example, $500 in total monthly debt payments divided by $2,000 in monthly gross income results in a debt-to-income ratio of 25 percent. If you have a debt-to-income ratio near or over 20 percent, this is a sign that you may have a debt problem.

Emergencies

It’s a fact. Crises and emergency situations happen, and people sometimes are unable to pay for such things as emergency auto repairs or medical expenses because their credit cards are tapped or the majority of their earnings are applied toward debt repayments. It’s always important to keep an open line of credit available for such situations.

You Make Only the Minimum Payments

What many people don’t realize about revolving credit card bills is that making only the minimum payment-or less-can take 12 to 15 years to repay. Making only the minimum payment means you are not applying any significant amount toward the principal. If you’re making only the minimum payments on your credit cards every month, you may be overextended and in need of putting together a spending plan.

Paying Off One Credit Card with Another Credit Card

Taking cash advances to pay bills is not a solution for paying off debts. Paying one credit card with another line of credit actually creates more debt. In addition to the amount equivalent to the original debt, you will be faced with any cash advance fees and interest from that new line of credit.

You Use Balance Transfers

Many creditors offer new credit cards with balance transfers available at low interest rates for an introductory period. It’s important to remember, though, that after the introductory period the interest rates typically skyrocket to 19 percent or more. Additionally, an increasing number of credit cards are charging fees for transferring balances. If you keep switching credit card balances, you may have a problem managing your finances.

Skipping Payments

Are you late paying your mortgage, rent, car loan, or utility bills more than once per year? If you juggle bills and skip payments, this is a definite sign that you have a debt problem.

Borrowing Money

If friends and relatives are constantly giving you money and you’re still short on your bills, credit counseling can help you learn how to budget or put you on a plan for paying off your debts. If you refinance your debts before they’re paid off, you’ll likely be subject to administrative fees and higher interest rates from lenders.

Debt Consolidation Loans

Are you borrowing from a new source to pay off an old debt? Many people who do so obtain debt consolidation loans to pay off all their existing bills. However, once the bills are paid off, some people wind up charging on their credit cards again. This means having to pay back the loan plus the new credit card charges, which drives people needlessly into further debt.

Unsure of the Amount Owed

Many people have no idea how much debt they carry on a monthly basis. If you keep using credit cards and are not tracking your spending, your financial situation could get out of control quickly.

Your Credit Card Payments are More Than Your Mortgage

If your combined credit card payments exceed your mortgage payment, you have too much credit card debt.

Your Credit Score Has Declined

If you are using too much of your available credit, your credit score will decline. A lower credit score will make it harder to borrow or consolidate debt at a lower interest rate, and thus harder to pay off the debt that you have accumulated.

Getting Turned Down For Loans

Getting turned down for a credit card or a mortgage is a sign that you have too much debt.

You Don’t Have Enough Money for a $1000 Emergency Fund

If you don’t have a $1000 emergency fund and your debt payments make it impossible to save one in 3 months, you have too much debt.

You are Getting Calls from Collection Agencies

If you are afraid to answer for your phone because you think it might be a bill collector, you have too much debt.

You Have Asked for an Advance on Your Paycheck

Not having enough income to pay for your expenses and your debt payments is a sign that your debt has grown too much. Taking an advance on your salary will likely make your situation worse next month.

You use Payday Loans

Using payday loans is another sign that you are in over your head with debt and you need help.

Your Net Worth is Less than Zero

If you owe more than you have, you have a negative net worth. This is another sign that you have too much debt.

The Impact on Your Financial Health

Let’s return to that sneaker analogy. Debt is like having 100-pound lead weights strapped to each foot.  It keeps you from running freely through much of life.

It can keep you from getting loans, owning a home, investing in your future, having a comfortable retirement, paying for emergencies and simply having enough to buy Christmas presents.

It adversely affects your credit score, since 30% of that calculation is based on the amount of debt you have. The worse your credit score, the more you’ll pay in interest on credit cards and loans.

Beyond the financial havoc, debt can have an incalculable emotional effect. A host of studies have shown a correlation between mental illness financial problems.

A report in Clinical Psychology Review said people with debt have three times the occurrence of mental health problems as those who are debt-free. The issues include depression, anxiety disorders and even suicide.

There are a few things in life worth dying for, but debt is not one of them.

How to Deal With Too Much Debt

Between the warning signs and the debt-income-ratio, 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.


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