Debt has become a shared reality for most consumers. Mortgages, car loans, credit cards – it’s basically impossible to function in our society without taking on one form of debt or another. When a market crash always seems to be looming on the horizon and economic uncertainty becoming a constant, it’s very reasonable to ask how much debt you should take on.
There are a lot of answers to that question and a lot of different lenses we can look at debt through. We’re going to start by looking at different kinds of debt. From there, we’ll look at how debt interacts with other spending. After that, we’ll look at some of the standards financial professionals use. With all of that information in mind, you should be able to make better decisions about debt.
Different Kinds of Debt
There are a lot of different debts you can accrue – too many to list here. These debts will all come with different terms, different interest rates, and different responsibilities. To better evaluate whether or not you have too much debt, it’s important to understand what kinds of debts you have.
Let’s start by considering interest rates. Let’s say you have two credit cards: one with excellent rewards but a 20% APR (Annual Percentage Rate), the other with minimal rewards but an APR of 10%. When you’re financially stable, the credit card with the higher interest rate is better – you know you’ll pay it off every month. On the flip side, when you’re living from paycheck to paycheck, you’ll want to use the card with a lower interest rate. That way, if an emergency comes up and you take a financial hit, you won’t have to pay as much interest.
What the debts are for
Another way of looking at debt is evaluating what the debts are for.
- Car loans: Car loans, for example, are bad debts. You’re buying an item that depreciates over time, so you’re effectively losing money. What’s more, you’ll have to pay more month-to-month than you would buying the car with cash. That’s not to say you shouldn’t get a car loan – people need to get around. Rather, it’s to say you should know that your car isn’t an asset (in a financial sense) and you should opt to buy it in cash if you can.
- Mortgages: A mortgage on your house, conversely, is often a pretty good debt. Houses are almost always appreciating assets – the longer you’re in your house, the more valuable it becomes. You’ve taken on debt but the value of your home may very well grow to be more than the amount you owe plus any interest. You should know that even though houses typically increase in value, that’s not always a surefire bet. What’s more, if you can’t make your mortgage payments on time, you could lose your home.
- Collaterals: Collaterals are an important element to consider when you’re thinking about the different kinds of debts. Whenever something essential to your daily living is on the line, that’s a debt you’ll have to pay on time, so it will take precedence over other debts you may have.
How Debt Interacts with Spending
You know the old saying – you’ve got to spend money to make money. That’s true! You need to spend money to live, and if you’re not living, you’re not making money. When you’re considering your debt, you can’t consider it in a vacuum – you need to think about how much money you’re taking in and how much money you’re spending on things that aren’t debt.
Take, for example, your mortgage. For most of us, a mortgage on its own isn’t too hard to handle. It’s when you throw in repair costs, utilities, home insurance, and taxes that home ownership starts to become quite burdensome. When you’re evaluating how much debt you can take on, it’s important to have a holistic approach.
You should more or less always be saving money. That money can go toward a variety of different things – retirement savings, education, funds for your children, or a simple nest egg in case things go awry. Saving in this way is especially important if you have a variety of debts that you’re paying on time. The situation is a bit tricky because the tighter spending is, the more money you want saved up; that way, if you fall on hard times, you’ll still be able to pay your debts.
That’s one of the reasons you should almost never be putting anything on a credit card that you can’t pay back immediately. Credit card debts are bad debts and their interest rates hits hard.
Guidelines that Experts Use
The most important thing to glean from the last two sections is that the kinds of debts you’ve accrued, as well as your unique financial situation, are the things that should dictate how much debt is too much. That said, there are a couple of guidelines you can use.
One of the easiest guidelines is the 28/36 Rule. That rule dictates that all annual home-related expenses, from mortgage to taxes, should amount to 28% of your annual income. You can then have other debts account for 8% of your annual income, leading to a total burden of 36%.
You should almost never have more debt than that; when your debt-to-income ratio is 40% or higher, you’re going to have a hard time getting more financing.
Talk to Experts
These are, of course, all guidelines, and the best way to determine your financial health is to consult with a number of different experts. Financial advisors can help you analyze the kinds of debt you have and can propose ways of reducing your debt load (if you need to). You might opt to get an accountant; the expense of managing accounting yourself can exceed the costs of professional services. You never know what tax breaks you can get from an expert in the field!
When you’re faced with high amounts of debt and you’re feeling overburdened, get in touch with a debt relief specialist. They’re like financial advisors but they’re specialized in finding ways of reducing your debts.