How to determine how much debt is too much

There are lots of resources that say they can help consumers manage or get out of debt. But there are very few that try to help consumers avoid too much debt in the first place.

Many consumers, especially young adults, begin accumulating debt before they really have an understanding of what it is and how it works. Before they know it, they’re having trouble making ends meet.

In short, debt is a financial instrument that allows you to live above your means. You borrow the money to make a purchase that, if you had to pay for it all at once, you couldn’t afford.

A good example is a house. Most consumers can’t come up with $100,000 or more to purchase a home. To buy a home, most people get a mortgage, which is a loan with a term of as long as 30 years.

In most cases, mortgage debt is okay

Even though this is the largest debt most consumers will ever take on, it can be the most benign — although it wasn’t for people who purchased at the height of the housing bubble. But if the monthly mortgage payment is comparable to what the consumer would be paying in rent for a place to live, the debt becomes manageable.

That’s the key — being able to manage your debt. And this is where so many people go wrong. They run up high-interest credit card bills on multiple cards, take on a couple of new car payments and end up borrowing more money to make payments on old debt.

Before the economy crashed in the Great Recession, consumers were using debt to keep the economy growing. When credit sharply tightened in late 2008, consumers and the economy suffered.

Household debt is down

Since then, many consumers have worked hard to pay down debt. According to the U.S. Census Bureau, the percentage of U.S. households holding some form of debt declined from 74 percent to 69 percent between 2000 and 2011.

That’s the good news. The bad news is the people who still have debt have more of it. The median amount of household debt increased over this period from $50,971 to $70,000 in 2011 constant dollars.

While the stereotype is young consumers running up credit card debt, the report shows it’s older consumers who have experienced the largest percentage increase in debt.

“Those 65 and over became more likely to hold debt against their homes, and their median housing debt increased, as well, which explains a significant portion of the increase in their overall debt between 2000 and 2011,” said Census Bureau economist Marina Vornovytskyy.

This is not to suggest you should avoid debt altogether, although some people definitely hold to that view. Rather, the question is how much debt is manageable?

Debt-to-income ratio

For a clue, let’s look at it from a lender’s perspective. When you apply for a mortgage, the lender will measure your debt and obligations and arrive at your debt-to-income ratio.

This is the percentage of your monthly gross, pre-tax income that is used to pay your monthly debts. It’s a combination of two number. The first is the percentage of your income that will be used to pay your mortgage. The second number adds in other debt — car payments, credit cards, installment and student loans.

The mortgage industry wants that second number to be no more than 38, meaning the borrower’s combined debt payments each month, including mortgage, should take up no more than 38 percent of their gross, pre-tax income.

Chances are, most consumers have no idea what that number is so it is easy to get over-extended. Credit card debt is especially hard to manage because the interest rates are high and the minimum payment required isn’t usually enough to make much headway on paying it off.

Pay credit card balances in full

That’s why consumers who are just starting out should avoid allowing credit card balances to accumulate. Do not purchase something with a credit card that you cannot pay for, in full, at the end of the month. In some cases a major purchase, like a new refrigerator, could be carried for a short time. Just make sure you have a plan in place to pay it in full within a short period of time.

But when you charge restaurant meals, for example, make sure you pay for those, in full, at the end of the month. A meal at your favorite restaurant, running up interest charges of 21% each month, will turn out to be very expensive.

Avoiding too much debt requires a household budget. Make a list of monthly expenses, divided between “needs” and “wants.” Making these hard choices can help you avoid getting into debt in the first place.

Mark Huffman

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