How much debt can I carry?

With the world slowly returning to normal, many people are carrying debt that accrued during the pandemic. But now that life is looking up, consumer spending is on the rise. Every industry is looking to offer you a deal. Interest rates are ridiculously low and look like they’ll stay that way for a while. Buy a car, take out a personal loan, get another credit card. It all sounds so doable.

What do they all have in common? You’ll be paying them off for a long while.

Types of Debt

All debt is not viewed the same way, but they all pull on your credit score. When your debt goes up faster than your income, so does your interest rate.

Secured Debt: This is any loan you receive that is backed by collateral. Your house is your collateral for a mortgage. Your vehicle is collateral for a car loan. If you don’t make your payments, the lender can repossess or foreclose on the collateral to recoup their losses. Initially, the majority of the payment goes toward the interest. Later in the loan, more money is routed toward the principal.

Unsecured Debt: This is debt bound by a contract. They are risky for lenders, so the interest rates are high. If you default, the lender can take legal actions, like liens or collection agencies. Medical bills are an example of unsecured debt. Because of the dollars involved, bankruptcy is often the only option for defaulting.

Revolving Debt: This is unsecured debt that involves a monetary advance. Credit cards are the perfect example. They “loan” customers a set amount of money for their use, during a payment cycle. If the balance is paid before the due date, there is no interest charged. Any balance after the due date is hit with interest charges. The credit card industry makes its money off people who make partial or minimum payments.

Student loans are unsecured debt. The combined student loan debt in the U.S. is $1.57 TRILLION. That represents the 14% of Americans carrying student loans. In 2020, 6.5% of those loans are 90 days past due. These unsecured loans are the most common way of attending college.

It’s not only government-funded loans, some students get private loans or use home equity lines of credit. Then they use credit cards to fill the gaps. Student loan debt is an ever-expanding bubble. When it bursts, it will hit the economy like the subprime mortgage implosion of 2008.

Large amounts of unsecured debt and revolving debt raise red flags for lenders. You will receive higher interest rates on any new card, loan, or refinancing attempt. It will hurt you or possibly kill your chances of getting a mortgage. Your payment history can either help or hurt you, but the same people who let you get into debt aren’t going to help you get out.

How Much Is Too Much?

There’s a simple calculation for how much debt you can carry. Look at gross monthly income (before any taxes, including Social Security, are withheld.) Add up your monthly expenses. Divide your expenses by your gross income. Let’s do the math. (Which you should do every time you’re considering taking on new debt.)

To figure out your gross income, don’t add up your paychecks. They will have payroll taxes and benefits pulled out of them. Instead, take your annual salary. We’ll use $68,000. 

Now add up your monthly debt payments: $1200 Mortgage, $450 Car loan, $275 Credit Cards, $300 Student loans, $45 Gym membership, $150 hospital bill. Your monthly debt is $2,140.

We divide $2,140 by $68,000 to get your debt-to-income ratio. In this case, it is 38%. It’s not horrible, but it’s tight. Remember your gross income isn’t what you take home. You will still be able to get credit, but your interest rates will be a little higher. Let’s see what happens if you jack up your debt.

You want to buy new living room furniture. It’s a good deal, no interest for a year. The payments are only $260 a month. It’s just too good to pass up. You’ve been stuck in the house since the pandemic, it’s time to take a trip. You decide to go to Hawaii and get a great package on your flight and hotel. It ups your credit card payments to $775 but you really need a vacation. Then you blow a head gasket on your car, you’re looking at $1875. The mechanic has a financing program, you sign up. It’s $160 a month.

Let’s do the math again. Your monthly debt is now $3,065. Divided by your gross income of $68,000, your debt-to-income ratio is now 54%. Over half your gross income is spent covering your debt. If you assume your net income is about 20% less – yikes. The one good thing? Reputable lenders will just say no to letting you borrow.

Saying the Hard Part Out loud

Here’s the hard part about debt. Sometimes it’s necessary – a mortgage, a car loan. Other times it’s just not optional, as in the case of medical debt. But we acquire debt far too readily. The cars we buy, the shopping online, the home equity loans, the lines of credit we take – they all add up.

It’s amazing how easy it is to start drowning in debt. That furniture above was a good deal – interest-free for x amount of time is a common hook. But was it the right time to buy it? Especially if you wanted to go on vacation. Most of us don’t connect the dots. We see two separate transactions – furniture and vacation – when we should see the combined debt.

Then there’s the emergency purchase. If you don’t have the cash to cover it – you’re stuck. Maybe you don’t have the cash to cover it because you’re spending too much to keep up with your debt. Just something to consider.

Imagine if you did a debt-to-income ratio check before you bought your last car? Would you have changed the model, dropped some of the options? Maybe not, but debt is always easier to acquire than it is to get rid of. We used this calculator for the debt-to-income ratio. Run your numbers and take a look.

Anything under 35% is good. Anything over 45% will affect your ability to get a loan, a mortgage, or a credit card. Honestly, that’s probably a good thing.

Stay Away from Bad Debt

ball and chain

There are some options for acquiring debt that should be avoided at all costs.

Payday Lenders: These companies are the equivalent of a modern-day loan shark. They offer small loans, $1000 and under, that need to be repaid when you get your paycheck. Their fees are insane, charging an average of $30 on every hundred that’s borrowed. A $500 “loan” jumps to $660 before you start paying the interest. Which by the way is up to 400%.  That’s why they are prohibited in some states.

Title Loans: Otherwise known as how to get your car repo’d loans. When you take out a title loan, you put up your vehicle’s title as collateral. These are short-term loans, typically a 30-day term. Payments are required weekly or bi-monthly. The average finance fee is 25% of the loan. If you borrow $800, they tack on another $200. Now you owe $1000. Plus, title loan lenders are known to toss on a few other fees. If you can’t pay, they may offer to roll over your loan for another 30 days. Now your $800 loan costs you $1200.

Or they can just repo your car.

Customers for these types of companies are poor or desperate. Even when given the loan terms (in writing BTW) they have few options. What they see as a lifeline is actually a set of concrete shoes that will pull them further underwater. Payday lenders and title loans are not a solution.

(Read: How to Pay Off Credit Card Debt)

How to Get out of Debt

This is the part no one wants to hear: Stop buying stuff on credit. Credit card debt is the worst choice we make. During the pandemic, eCommerce stores saw a tremendous jump in sales. Stuck in our homes, we ordered everything online. Now that restrictions are limited, we need to break the plastic habit. When people shop with credit cards, they spend more money than when they carry cash.

If you’re trying to get rid of credit card debt, you have two choices: Stop shopping or only buy things you can pay for with cash on hand. (Debit cards are the online alternative.)

Let’s talk vehicles. In 2020, Experian reports the balance of car loans in the U.S. is $1.37 trillion. That’s the highest it’s ever been. Past due accounts began creeping up in 2020. Unless you have excellent credit and a low debt-to-income ratio, think about the long-term cost of a car. Kelly Blue Book says the average cost of a new car is just over $40,000.

Bear in mind, the car will lose between 15% and 20% of its value when you drive it off the lot. That’s eight grand you’ll be paying off for the next couple of years. Because the pandemic hurt the auto industry, they’re doing everything they can to sign you up for a new vehicle.

It doesn’t hurt to consider a used car. Just to be straight, the interest rate on the loan will be higher than a new car. Purchasing a used car that’s two or three years old is the way to spend the least. You still get some of the bells and whistles (think technology) at a much lower price. Any bumper-to-bumper warranties will pass along to you, so repairs are less of an issue.

Consequences of Default

A poor credit score is hard to fix. It can take years to recover, even if you’re able to hang on to your house. Once the lender is convinced they won’t get paid, they send the debt to a collection agency. This includes everything from credit cards to mortgages to utility bills.

Debt collectors tend to be relentless. They can call from 8:00 am to 8:00 pm. Some are less professional than others, threatening the debtor and their family with highly inflated consequences. There is a statute of limitations on debt that varies by state which you can check if you’re getting calls. You can also ask for written proof of ownership of the debt to make sure you’re not getting scammed.

The reality is the lawyers will get involved eventually. There will be liens and judgments that can further cripple your financial state. At that point, you may have to consider bankruptcy. There are two types of personal bankruptcy: Chapter 7 and Chapter 13.

Chapter 7 is the simple elimination of most of your debt. It does not forgive tax debt, back child support or alimony, and student loans.  In some states, you may be able to hold on to your home, but not if you’re already in foreclosure. Chapter 7 is the most common type of bankruptcy. It stays on your credit report for 10 years.

Chapter 13 is a payment plan that organizes your debt so you can pay it off. The court must approve a 3-5 year plan for you to pay off a portion of the debt. You can keep your house, even if it’s in foreclosure and other assets like vehicles. To be eligible, there are limits on the amount of secured and unsecured debt you can have. Chapter 13 bankruptcy stays on your credit report for seven years.

Don’t Carry Too Much Debt

If you’re already in debt, start digging yourself out now. Don’t wait until the proverbial poop hits the fan. You don’t have to close your credit cards but take them out of your wallet. Start saving for what you want instead of digging a deeper hole. No new loans, no new cards. Make more than the minimum payment on the cards you have and see if you can refinance the loans you’ve got. If you keep at it, your financial health will improve and your stress level goes down.

If your debt-to-income ratio is strong – keep it that way. Don’t buy on impulse – anything that requires credit deserves some thought. One accident, injury, illness, or termination will change your gross income in a second. Make sure you’re saving as much than you spend.

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