How much debt is OK, and How much is OUT OF CONTROL
Do you need to get your debt under control?
There is good debt and there is bad debt. Generally speaking, good debt is that which is necessary for living well. Mortgages and student loans, for example, qualify as good debt. On the other hand, credit card debt and other high-interest debt is generally considered bad debt. Even if you aren't in the situation where you need to reign in your debt, for example, in order to get a home loan, it is still important to know what kind of debt you are carrying. To make heads and tails of your debt situation, there are a few things you should consider.
The first, and most easily derived, indicator of debt is your debt-to-income ratio. Lenders use this ratio to calculate one's ability to carry debt, and thus one's loan worthiness. This ratio can be found by dividing your total monthly debt by your total monthly income. Be sure to include all major debts, such as car and student loan payments. However, you need not factor in day-to-day expenses like food, clothing, or utilities. Here is a calculator to help you discover your debt-to-income ratio.
DEBT-TO-INCOME RATIO CALCULATION
Mortgage Payment (include taxes and insurance)/Rent $
Home Equity Line of Credit/2nd Loan Payment $
Car Payment $
Revolving Credit Payments (furniture, appliances, etc.) $
Student Loan Payment $
Minimum Monthly Credit Card Payments $
Other Monthly Debt Payments (child support, alimony, etc.) $
TOTAL MONTHLY DEBT PAYMENTS $
Monthly Take-home pay $
Annual Bonuses and Overtime, divided by 12 $
Other Annual Income (interest, etc.), divided by 12 $
TOTAL MONTHLY INCOME $
Total Monthly Debt Payments Divided by Total Monthly Income = Debt-to-Income Ratio
In the eyes of a lender, a debt-to-income ratio of less than 36% is good, and less that 30% is excellent. If you are over the 36% mark, you can still get a loan, but it is likely you will get a higher interest rate on the loan, as lenders see a ratio over 36% as higher risk of default. If you are over 40%, your viewed as a poor candidate for a loan in the eyes of lenders. For home ownership purposes especially, you should try to get your ratio to the good-excellent mark. Reduce your debt or increase your income to get you to 36% or less.
While lenders will evaluate your debt-to-income ratio, they also consider heavily your credit score. Credit scores are mysterious to many people, because they involve a complex computation. However, there are a few essential things you should know about your credit score and about how to optimize the score you are given. The five determinants of your score are as follows:
- Payment History - 35% of score. You can increase your score by improving your payment history. This means making payments on time! Keeping the amount of accounts you are delinquent on to a minimum, or having delinquent payments that are relatively small rather than huge will assist your score, but you are best off never being late on payments. Liens, judgments, and collections against you will all affect you negatively.
- Amounts Owed - 30% of score. When credit is pulled, current balances are shown for all open credit accounts. Even if you pay off your card each month, whatever the balance on the card at the time of the credit check, that amount is what will be factored, so try not to run up your bills too much around the time you plan on having your credit pulled. Also, having a large number of credit accounts is considered negative, even if they have low balances, so try to keep the number of credit cards you have to three. However, low balances with high credit limits are considered positive, as it indicates you aren't maxing out your credit.
- Length of Credit History - 15% of score. This is essentially how long you have been in the Credit Bureau's system, because if they can track you for a longer period of time, they are more confident in the score they can give you. To make the most of this portion of your score, its best to open your first credit card when you are young. Other than that, there is not much you can do to influence this aspect of your credit score.
- New Credit - 10% of score. Inquiries into your credit history ding your credit score. Generally speaking, this doesn't pertain to home loans so much, as multiple inquiries (ie from multiple potential lenders) in a short period of time count as only one. However, refrain from opening new accounts often, or from checking your credit often.
- Types of Credit - 10% of score. Try to maintain a balance of installment and revolving credit, mortgages, and retail accounts. In other words, your credit portfolio should not consist of credit cards alone. This part of your score is mainly about balance.
To check your credit, you should contact one of the three credit bureaus: Equifax, Experian, and Transunion. You are legally entitled to one free report annually, and if you notice anything unusual or unexpected on your report, follow up with the specific bureau immediately. This is important not only for your credit rating, but also to keep your risk of identity theft or fraud to a minimum.
The last important factor when evaluating your debt is the interest rates you are paying on your various debts. It is because student loans usually have very low interest rates that they are considered good debt. However, car loans at 10% or the 18-24% you might be paying on a credit card balance are all bad debt. Generally, debt is considered good when the interest rate on it is manageably low. A rate of 8% or lower, on major purchases, is generally manageable. If possible, transfer your high-interest debt to a low-interest account (0% introductory APR credit cards, or even a home equity loan) and resolve to pay it off. It is always terrible to know that the $700 trip you took two years ago has cost you an additional $280 in interest, and you still haven't even paid for it.
If all else fails, here are some telltale signs that you are probably in too much debt.
- You don't have any money in your savings.
- You make only the minimum payments on your credit card.
- You have multiple cards on which you are carrying a balance.
- After paying off part of your credit card bill, you increase your balance by the same amount (or more) the next month.
- You are at or near your credit limit on your credit cards.
- You are unsure of how much debt you are in.
- You take out cash advances against your credit cards.
- You bounce checks.
- You get calls from debt collectors.
- You live paycheck to paycheck.
Review your debt situation to find out if you carry a healthy amount of debt or if you are in over your head. Understanding and reigning in your debt can affect your credit-worthiness and future financial situation, but it can also reduce the financial stress you currently experience in your life. If there is room for improvement in your situation, take measures to get your debt-to-income ratio, credit score, and interest rates in check.