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How do I know when I have too much debt?

16 July 2006

Many financially-savvy readers will be saying to themselves that you have too much debt when you have ANY debt. Technically, however, this just isn’t true. While you can certainly be financially healthy if you’re debt-free, it’s an unrealistic goal for most Americans and would actually hinder their financial health in many cases. There are two basic things you’ll want to consider:

1) What kind of debt do I have?

The first question matters because some debts might be better off left alone than paid off. Why would you want to be in debt? Well, it’s not so much that you WANT the debt – just that you’re better off having it and doing other things with your money. The two most common “good” kinds of debt are student loans and a home mortgage.

Student loans are usually locked in at very low rates, especially if you consolidated them. These low rates generally mean that you’re better off investing your money than paying down the loans. If you can earn 8% per year on the money in a generic, Standard and Poors Index Fund of stocks, why would you spend it paying off debt when you only “earn” 3-4% of interest you no longer have to pay?

Mortgages are another example of debt that is often a necessary evil. It’s nearly always better to own a house than to rent – and for most people, borrowing is the only way to do it. You should pay your mortgage down until you hit the threshold where you no longer have to carry insurance – usually this kicks in when you have 20% equity in the home. After that, there are probably better investments than repaying your mortgage debt, both because you can deduct interest on your taxes on your residence and because money you put into stocks will “compound” – you’ll get gains on the gains, whereas you get any increase in the value of your house regardless of whether you pay down the debt.

What about the bad kinds of debt? Anything high interest. Auto loans are often necessary, but you’re much better off if you can pay them down or eliminate them entirely, because they suck away money that could be used for investments – and in many cases at fairly high interest rates. Credit cards are a no-no, and ideally you shouldn’t owe a cent. But there are even worse forms, such as pay day loans or pawn shop loans. Avoid these unless you’re in a dire emergency – and even then, they’re usually not a good idea. If you owe any of these ultra-high interest loans, you should always consider yourself in too much debt and begin focusing your budget around paying them off.

2) What percentage of my income am I paying each month to keep up on my debts?

This calculation is crucial. There is a calculator here that will help you perform it in more detail. A good rule of thumb is that with mortgages included, your debt should not be higher than 40% of your gross income. This means you take the salary you make before taxes and any sort of deductions – let’s say you make $2,000 a month pre-tax. That means you shouldn’t be paying more than 40% of this, or $800 a month, on all your debts combined. This is regardless of whether your debts are considered “good” or “bad” kinds of credit to have - even too much of a good thing can be bad. If you don’t have enough money each month for basic living expenses, you’ll be tempted to use the credit cards. You also won’t be able to sock away a decent amount for your savings – a crucial part of making sure you can retire.

This leaves us with two basic rules for when you NEED to start reducing your debt levels:

1) If you owe anything on your credit cards, on a high interest car loan, or on any other high-interest debt (any rates above 7% per year).

2) If you are paying out more than 40% of your gross income each month in interest payments.  

Discuss this in the Free The Drones Forums here.

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