How much debt is too much?
If you think the answer is simple, you may not understand the question.
That鈥檚 often true in life, but particularly so when we鈥檙e talking about debt. Simplistic, one-size-fits-all answers actually suit relatively few real people.
At one extreme are those who curse debt as a four-letter word and vow to avoid it entirely. At the other are those who revel in the notion of using 鈥渙ther people鈥檚 money鈥� as much as possible.
In the middle live the rest of us, who understand that debt can be a tool to build wealth or destroy it, depending on how we wield it:
- Student loans can dramatically boost our earning power or strap us to a lifetime of payments that crowd out other goals, including buying a home, having kids and saving for retirement.
- Mortgages can help us build equity for the future or drag us down into foreclosure.
- Auto loans can help us buy safe, reliable cars or put us on a treadmill of debt for rapidly depreciating assets.
- Business loans can help us launch or expand a company 鈥� or tank that same enterprise, draining our wealth and putting a lot of people out of work.
So how do we use debt, rather than be used by it?
No one will stop you from taking on too much debt
Start by understanding that lenders will give you far more money than you can comfortably repay. You have to set your own limits and stick to them.
One gauge I like is the 50/30/20 guideline developed by bankruptcy expert and now U.S. Sen. Elizabeth Warren and her daughter, Amelia Warren Tyagi, in their book 鈥淎ll Your Worth.鈥� They recommend limiting your 鈥渕ust have鈥� expenses 鈥� for shelter, utilities, food, transportation, insurance, child care and minimum loan payments 鈥� to half your after-tax income. That leaves 30% for wants, such as eating out and vacations, with the remaining 20% devoted to saving and paying down debt. If a debt payment you鈥檙e considering adding can fit in under that 50% wire, they say, then you can probably afford it.
Keeping to 50% is going to be tough if, as is the case for many people in major cities, nearly half of what you make goes to your mortgage or rent. In Los Angeles, where I live, people spend an average of 47% of their incomes on rent.
But the guidelines also explain聽. They simply don鈥檛 have enough room in their budgets to do everything that needs to be done, including saving for the future and paying off the past.
How much house is too much?聽Most mortgages are made under guidelines that cap total debt payments, including housing costs 鈥斅爌rincipal, interest, taxes, insurance and association fees聽鈥斅燼t 31% to 36% of income, although the limits can be stretched to 45%.
Those limits may have made sense in some misty past, when most people could count on regular pay raises to shrink the relative size of their payments over time. Previous generations paid less for health care and college, plus they didn鈥檛 need to save as much for retirement, thanks to shorter lifespans and the greater prevalence of traditional pensions.
Today, with stagnant wages and an uncertain economy, a housing payment that eats聽one-third or more of your gross income isn鈥檛聽really sustainable. That聽doesn鈥檛 leave you enough room to聽聽and still afford your life 鈥� particularly if you have student loans or other debt payments and kids you need to educate.
Capping housing costs at 25% of your income can give you the financial flexibility to juggle all the other important financial goals in your life. Also, aim to have your house paid off by the time you鈥檙e ready to retire. That means not jumping into another 30-year loan in your 40s, regardless of how great the rates are. Pick the聽听颈苍蝉迟别补诲.
How much student loan debt is too much?聽Student loans are another area where people with good intentions wind up in a horrible bind. In general, college students shouldn鈥檛 borrow more for a degree than they expect to make their first year out of school. (See 鈥�.鈥�)
Parents shouldn鈥檛 borrow at all, unless they鈥檙e able to pay off the loans before retirement age while still being able to save adequately for retirement.
Ideally, your payments should eat up no more than 10% of your gross income.
How much auto debt is too much?聽Many people take on way too much, as I wrote in 鈥�.鈥� Figuring out what鈥檚 affordable depends on your other expenses, but most people should try to聽聽in the range of 5% to 10% of gross monthly income.
Car loans should be for four years or less and ideally accompanied by a 20% down payment so you don鈥檛 spend years owing more than the car is worth.
How much credit card debt is too much?聽Overspending on any of the above leads many people聽, and that isn鈥檛 smart. Credit cards should be used as a convenience, not a way to finance things you can鈥檛 afford out of pocket.
Pay your balances in full every month.
That may seem extreme. It鈥檚 not.
A lot of households have no credit card debt at all. 聽But if you have a balance so big it would take you a year or even longer to pay off, that鈥檚 a problem 鈥� and it didn鈥檛 get there overnight. It began the first month you let the balance roll over.
Any debt like these is too much
Truly toxic debt, to be avoided at all costs, includes:
- Payday loans
- No-credit-check loans
- Title loans
- Rent-to-own schemes
- Any other debt that has you paying two or three times over for whatever you鈥檙e borrowing (or even more)
What if this advice is coming too late, and you鈥檙e drowning in debt? It may be time to seek professional help, in the form of credit counseling or a bankruptcy attorney, if any of the following are true:
- Your consumer debts 鈥� credit cards, medical bills, personal loans 鈥� total聽half or more of your current income.
- You鈥檙e borrowing from one credit account to pay another.
- You鈥檙e being sued over your debts.
- You鈥檙e losing sleep or fighting with a partner over debt.
Debt shouldn鈥檛 rule your life. But unless you take charge, it will.
This article first appeared at .
