How much debt is too much?

Studies today show that many people are carrying a lot more debt than ever before.  With difficult economic times everywhere many people are wondering how much debt is too much.  Most people have some kind of debt in the form of a mortgage, an auto loan, a student loan, or even a credit card balance. Having debt isn't a bad thing as long as you are taking steps and working towards paying it off. But it is important to keep in mind that having too much debt is what can cause an unhealthy financial life, and unnecessary stress. Taking the time to evaluate whether or not you have too much debt can provide confirmation that you are doing things right or the realization that some financial changes are needed. Here is what you need to know if you are asking: how much debt is too much?

•     Debt to income ratio-One of the best ways to calculate your debt load is by figuring out your debt-to-income ratio. This is the amount of debt you are carrying relative to your income. You can calculate your debt-to-income ratio two ways either by including good and bad debt, or you can leave out good debt.  Good debt is typically considered a mortgage, student loan, and any other debt that carries low interest. Bad debt is simply everything else. If you really want to gauge your debt overload, it's typically better to calculate the ratio considering only bad debt. On the other hand, if you want a complete picture of your debt, include both good and bad debt. A bank will tell you what they consider to be too high of a debt to income ratio, but only you can really know if your debt is too much.
•    Calculating debt overload-To begin let's assume that you want to gauge your debt overload (bad debt only). Simply add up the amount you spend each month on your bad debt and divide it by your total monthly income. Multiply the resulting number by 100 to come up with a percentage. The result is your debt-to-income ratio. For example, let's assume you make $4,000 a month. Let's also assume you spend $400 on credit card payments and $450 on an auto loan. Your ratio calculation would be $850 / $4,000 = 0.22. Multiply that by 100 for a debt-income-ratio of 22%. In this example, you spend just under a quarter of your income on bad debt. It is important to keep in mind that when it comes to debt, whether good or bad, the lower the debt you have, the better. Most financial experts consider a bad debt ratio anything beyond 10%.  Having a debt to income ratio over 10% is too high and often is a sign that you are overloaded with debt. This is especially true if you are not counting good debt in your calculations. The fact is that if you were to lose your job with layoffs happening all around, having less than 10% debt can result in being able to manage. The higher that number, the harder it is going to be to keep your head above water when you do have a job, let alone if you were to lose your job.

•     Understanding your total debt-It is also important that you understand your total debt.  Many times people feel that if they are carrying little bad debt it is all right to go crazy with "good debt".  What does this mean? It means that since they are buying good things, like a house or education, that overspending is all right. This is simply not the case. This results in buying a house you cannot afford, taking out too much student loan debt etc. What happens when you can't meet your monthly mortgage obligation?  The problems that can result are the same whether you are carrying too much good or bad debt. Not being able to pay your debts is going to damage your credit history, and lead to financial crisis whether those debts are for good things, or on your credit card. You should evaluate your total debt picture frequently, including both good debt and bad debt to determine if you could and should be living more frugally. The calculation is the same as in the previous example; the only difference is that you include all your debt rather than just bad debt. To calculate your total debt-to-income ratio, simply add up your total monthly debt expenses. Remember, this does not include recurring payments, such as your television service, as that is not a debt. However, it should include payments for credit cards, student loans, mortgage or rent, child support or alimony, and other loans or credit cards, including department store cards. Next you need to total your monthly income, including take-home pay, alimony or child support, bonuses, or dividends. You then divide your total debt payments by your total income (don't forget to multiply by 100) for your debt-to-income ratio. When making the calculation be sure that you do not include extra income that is not consistent. For example, if your grandmother passed away and left you money, you would not include that in your income tally because it will not be there monthly, and thus does not reflect on your ability to pay your debts. You should have a total debt-to-income ratio, (considering both good and bad debt), at 36% or lower. A ratio lower than 30% is considered excellent, while a ratio over 40% is a red flag for a potential financial disaster. This is because you have to have money left for your living essentials such as food, utilities, and fuel. When your debt gets too high, you have little room to pay for the essentials, and it often results in much greater debt.

If you determine that you have too much debt do not despair!  You can put together a plan to lower your debt.  This will not only make your finances easier to manage, it will improve your credit too. It is important to understand that debt is a cycle, the more you have, the more you will get into. Why? Because if you have half of your monthly income paying down debts, and you have an emergency, you won't have money to pay it, and thus get into further debt. If you have a lot of debt, sometimes you feel like your finances are already out of control, and you exercise less discipline, and continue buying things that you simply can not afford.

For some, the answer to how much debt is too much is any. Any debts outside of your home and education are generally considered unnecessary debts. With proper financial management, you can usually avoid such debts. However, there are going to be times when you do get into debt for things like a car. Having a vehicle is important as it can facilitate being able to work and bring in an income, but that does not mean you should go out and buy a Cadillac Escalade when a Hyundai accent is more in your price range.

Too often people justify their debts, which lead to getting deeper and deeper into debt. You have too much debt if you are living beyond your means. You have too much debt if you owe money on items that are more expensive then you should have (such as a 3500 sq. ft. home for a family of 4 making $40,000 a year).

When determining if you have too much debt, ask yourself how long you would be all right if you lost your job. Does your large debt load make it impossible to save? Would you have a way to pay your debt obligations if your income was reduced? Basically, how big of a burden is your debts creating for you? The less debt you have, the more freedom you have.

So, to determine if your debt is too much, evaluate your total debt to income ratio, determine if it fits within the acceptable range (under 36%), and then determine if in your specific case if it is too high. For someone who spends very little on extras, like eating out, clothing, entertainment, etc. a 36% debt ratio is more manageable than for someone who after their debts tries to carry on too extravagant a lifestyle. No one but you can really account for how tight your money is going to be if you incur more debts, etc. So, while calculating your ratio is a good first step, also evaluate how well you do at controlling your other expenditures. If you consistently find yourself spending more than you make, you need a smaller debt load because you will be needing the extra room in your budget for your expensive tastes or uncontrolled spending habits.