Almost everyone has some kind of debt. It could be a mortgage on a house, a car loan or several credit cards. Some debt is OK, but too much debt can get you into serious financial trouble.
Here are some signs that you have too much debt and a few guidelines on how to manage your finances to stay within the recommendations.
Lenders are looking for borrowers who have shown the ability to manage their money.
Signs of Too Much Debt
You'll know you've got too much debt when you're:
- getting late on your monthly loan payments
- paying off one credit card with another credit card
- only making minimum payments on your credit cards
- using up your savings and don't have an emergency fund
- not contributing to a retirement plan
- living from paycheck to paycheck
- using credit cards to pay for everyday expenses, like groceries and gas
- feeling stress
Consider also: What Is a Debt Holder?
How Much Debt Is Too Much?
The Consumer Financial Protection Bureau (CFPB), a government resource for information on personal finances, recommends that your debt-to-income ratio should not exceed 43 percent of your gross income. Statistics show that when someone goes above this figure, they'll begin to fall behind on their payments.
To find your debt-to-income ratio, you divide your total monthly debt payments by your gross monthly income. Suppose, for example, you have a mortgage payment of $1,800, a car payment of $425 and minimum credit card payments of $375. Your monthly payments would total $2,600.
You do not include payments for such expenses as utilities, cell phones, insurance, internet or monthly subscriptions.
If your gross monthly income is $7,500, then your debt-to-income ratio would be just about 35 percent ($2,600 divided by $7,500).
Consider also: What COVID Has Done to Our Personal Debt
What About Credit Cards?
The guideline for credit card debt is that the utilization should not exceed 30 percent of your total lines of credit.
Suppose you have three credit cards with maximum lines of credit of $3,000, $4,000 and $2,500. Your total lines of credit would add up to $9,500. You'd want to keep your utilization less than $2,850 ($9,500 times 30 percent).
Utilizations above 30 percent will have negative effects on your credit rating, which, in turn, could lead to being charged higher interest rates.
Consider also: Credit Card Debt Relief: What Are My Options?
Managing Your Budget
Lenders are looking for borrowers who have shown the ability to manage their money. Staying within these guidelines are examples of how well borrowers pay attention to financial management and give lenders more comfort that their loans will be paid back on a timely basis.
With these measures of debt in mind, you can manage your income and expenses to meet the guidelines.
Personal Money Management Example
Here's an example. Suppose you're paying $1,500 in monthly rent, your minimum credit card payments total $175, your gross income is $5,000 per month, and you want to buy a new car. How much can you afford to make in a car payment?
To meet the 43 percent debt-to-income ratio requirement, your total monthly payments cannot exceed $2,150 ($5,000 times 43 percent). You already have $1,675 ($1,500 plus $175) in monthly payments. Subtracting $1,675 from $2,150 leaves $475 available for a car payment that will keep you under the 43 percent.
Should you use the full $475 availability for a car payment? You could, but that wouldn't leave any room for additional payments. Suppose you wanted to move to another location and your rent would go up to $1,800. You might be able to make the payment if you cut back on your discretionary spending, but going above the 43 percent could make it difficult for you to qualify for other loans, such as a mortgage.
Wise planning would suggest that you keep your car payments lower, say $300 to $350, to leave yourself a cushion.