Knowing Your Limits: How much debt is too much?
It’s a common question that people with credit cards and other forms of debt ask themselves: “How much is too much?” This is an important question to ask yourself before you let yourself get in over your head.
reports that the average U.S. household with at least one credit card carried nearly $16,000 in credit card debt in 2012. This number is good and well, but depending on how much money that household is bringing in each month, that amount of debt could seem very small or almost insurmountable.
Before you sign for another loan or add to your credit card debt, determine your debt-to-income ratio. It's an important number used to gauge your financial situation and will give you some perspective on your debt load.
How to calculate your debt-to-income ratio
U.S. News provides a debt-to-income ratio calculator
you can use to find a more definitive answer to whether or not you have or are incurring too much debt. To calculate this ratio, add all monthly debt payments, such as your mortgage or rent, minimum credit card payments, car loan payments, and other loan obligations and divide that number by the total of all your monthly income, such as your annual gross salary, overtime, bonuses, alimony, and any other income divided by 12. This number is your debt-to-income ratio.
Now that you have this number, what does this percentage actually mean? According to U.S. News
, if your ratio is 36%or less, you are considered to have a healthy debt load for most people. In fact, other sources
report that a score of 30%is deemed excellent by lenders.
A score of 37-42% is considered not bad, but it’s suggested that you start paring debt immediately before any problems arise. A ratio of 43-49% means that your finances are in trouble unless you immediately take action, and if you’ve reached a score of 50% or more, you need professional help to aggressively reduce your debt problem.
When does debt makes sense?
While some say that you should avoid debt at all costs, a little of what is known as “healthy” debt is actually relatively normal and certainly acceptable. Healthy debt is considered that which is necessary for a better quality of life, such as a mortgage or car. Unhealthy debt is more along the lines of debt with a high interest rate, such as from credit cards or collections agencies.
While it’s good to keep debt to a minimum whenever possible, it’s not necessarily a good idea to deplete your cash reserves just to keep that debt low. This depletion could mean that you don’t have the money you need when an emergency strikes, such as an unexpected hospital visit or repairs for your car or home. You want to pay back what makes sense for you each month without reducing your savings to an unsustainable level.
The bottom line is to take your debt-to-income ratio into consideration and only get into the amount of debt that you can readily afford on a monthly basis. Keeping your balances in check means that you will maintain a realistic amount of debt and prevent yourself from drowning in zeroes when it comes time to take out a loan or check out your credit rating.
Knowing how much debt is too much is crucial to a better quality of your financial life. Don’t wait until it’s too late. Calculate!
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