How Much Debt is Too Much Debt?
Managing your house and car payments is difficult enough. Overspending and poor budgeting can put you on the brink. How much is too much debt? Understanding your debt to income ratio will help.
Everybody has some level of debt. Some is good debt and some is bad debt. To understand the difference is to understand your true debt load.
Good Debt
Good debt is considered as that which is taken out for items that will appreciate over time. Good debt is like an investment. How can debt be compared to investment? Purchasing a home is a great example of good debt because a home appreciates (goes up) in value, especially if you upgrade that home.
Taking out a student loan is another good example of good debt. Going to school raises your earning power so you earn more over your lifetime.
Bad Debt
Bad debt is exactly the opposite. This is debt accrued for consumable items like food or clothing. That sounds weird since we all need food and clothes. However, if you use a credit card to buy those things on a regular basis, you are incurring long term, high interest debt as a result.
So how can you tell if and when you have too much debt? The answer is simple and you can do it yourself without the aid of a financial professional.
Do I have Too Much Debt?
1. Write down ALL your debt, good and bad, on paper, then add it up.
2. Next you need to figure out your gross(before taxes) monthly salary. If you are an hourly worker, take the last six months, add them together and divide that by six to average it out.
3. Take the amount of money you spend on debt payments each month and divide it by your average monthly salary. Then multiply that number by 100 to get a percentage.
This figure is your debt to income ratio and it should be less than 30% typically.
Here is an example:
Bob’s average gross monthly salary is $5000. He pays a total of $1500 a month on debt payments. That makes Bob’s debt to income ratio 30% |
You can also make this calculation using your net income if you want to. Your net income is what you actually bring home on your paycheck. Obviously, your ratio is going to be higher but you will have a clearer picture of where you need to "cut the fat" out of your budget.
You can also do the calculation with only your bad debt (credit cards, etc).
As a guideline, if your debt to income ratio is:
Under 30% is Excellent |
Here’s another way to look at it:
Consider that taxes are taking 30% of your gross salary, you're saving 10%, and loan payments are at 35%, you're left with just 25% for everything else.
Put in terms of numbers, this leaves you with $250 out of a $1000 gross paycheck. Kinda depressing, huh?
This is why its so important to get out of debt fast and start saving for your future.
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