Home > Debt Help Advice > Do I Have Too Much Debt?
For American households, debt has become a way of life and in some of those houses, the figures are staggering.
Household debt (mortgage + home equity loans + credit cards + student loans + auto loans) in the United States reached $12.58 trillion at the end of 2016, an astonishing rise of $460 billion for the year. The typical American household carries an average debt of $134,643.
Whether it’s mortgages ($176,222 average debt), student loans ($49,905), auto loans ($28,948) or credit card debt ($16,748), money issues are rampant through every age group.
America’s median income has risen 28% since 2003, but the cost of living has increased 30% during that span. Meanwhile, medical costs are up by 57%, while food and beverage prices have risen 36%.
Ric Edelman, a syndicated radio host who has written eight books on personal finance, said at least part of the American debt plightcan be blamed on alack of financial education.
“Once you show people how money works, they almost instantaneously change their behaviors,” Edelman said. “There are a few people who are spendthrifts, who are psychologically in a place where they spend their money and can’t control themselves, but overall, people who spend money poorly simply don’t know what they’re doing is bad.”
How MuchDebtIs Too Much?
There are common fixed expenses for nearly every American household that can’t be avoided. It’s impossible to avoid mortgage/rent; auto; credit cards and, in many cases, student loans.
The question that should be answeredis what the spending limit should be in each area? Here are some guidelines from financial expertson how much to spend in these areas.
Most mortgages fall in the range of 31% to 36% of total income, including principal, interest, taxes, insurance and association fees. In some cases, usually in larger cities, it can push upward of 45% to 50%.
Those limits might need adjustment in times whenregular pay raises can’t be counted on.Plus, past generations paid less for health care and college. Due to shorter lifespans and greater pensions, there wasn’t as much pressure to save for retirement.
So, what is reasonable? By capping housing costs at 25% of your income, it will give you flexibility in other areas. It should also allow you to have the house paid off by retirement age. It’s a huge advantageto choose a 15-year mortgage and stick with it,but reality for mostpeople is thatthe lower monthly payment of a 30-year mortgageis more comfortable.
When it comes to student loans, ideally you won’tborrow morethan youexpect to make during yourfirst year out of school. Parents shouldn’t borrow at allto pay for a child’s education because it willinterfere with retirement savings. Aim for 10% of your gross incometo go toward student loansand try to paythem offas soon as possible.
Automobiles are not a good investment. Car payments should be no more than 5% to 10% of gross monthly income. Shoot for a four-year loan and a 20% down payment to maximize your flexibility.
Credit cards always arethe area of most concern. The smartest goal is to shoot for zero credit cards.
Zero?OK, make it one credit card … and for emergency use only!
Your financial life is much more manageable when you use a credit cardto financeunexpected circ*mstancesyou really can’t afford, like an automobilerepairor home repair or maybe a medical emergency.Credit cardsbecome a nuisance when you use them topay for anything and everything from groceries to gas to utility bills, clothes shopping, entertainment and so on.
If you’re going to use a credit card, do itwith discipline,reasonable spending expectationsand the goal of paying off the debt every month. At the very least, make more than the minimum payment and don’t saddle yourself with more unneeded purchases.
“Modern life can be difficult,”Houston financial advisor JosephBirkofersaid.“People choose debt instead of going without, so the problem keeps growing. At some point, I think you do have to say that enough is enough.”
DebtToIncome Ratio
One of the methods lenders use to determine if you have too much debt is by pouring your regular expenses and income into a formula and coming out with something called a debt-to-income ratio or DTI.
Your DTIis expressed as a percentage throughthis formula: recurring monthly debt ÷ gross monthly income = debt-to-income ratio.
There are two ways to determine your debt ratio, one involving your mortgage payment, one leaving it out.The one involving mortgage (or rent)paymentsis the one most often used by lenders in deciding whether to approve a loan so we’ll begin there.
Add upall your monthly debt payments, things like credit card bills, auto loans, student loans,personal loans and the rent/mortgage payment.Divide that figure by yourgrossmonthly take-home income, which is your incomebefore taxes and other deductions are taken out.
So, for example, let’s say your total monthly debt payments equal $3,000 and your gross monthly income is $6,000. The math for thatis 3,000 ÷ 6,000 = .50 or 50%.That is considered extremely high. You have more debt than you can handle.
When mortgage/rent is included in the equation, lenders like to see a 35% or less DTI ratio. The housing industry will make you a loan with a DTI as high as 43%, but your interest rate will reflect the increase risk to the lender and be very high.
The other method for DTI – seldom used – is the same formula, minus your mortgage/rent payment. The resulting figure should be10% or lower. That means your debts should account for 10% (or less) of your income. If it’s a larger figure, bells should be clanging in your head.
Potential fixes? The simple answer is to a) cut expenses; and b) increase income.Unfortunately, it may take a while toadopt either habit.
“These are habits that are best established early in your life, but I see young people as being a very vulnerable group,” said George Washington University professor Annamaria Lusardi, who is considered one of the world’s foremost experts onpersonaldebt. “We have a $1.3 trillion student loan debt in this country and we also have a huge part of the population that doesn’t grasp the concept of compound interest.
“These young people start their adult life in debt. They are highly leveraged. It leads to mismanagement of their finances, which perpetuates the debt problem we have today.’’
Here aresome tell-tale examples that your debts have climbed too high:
- Your consumer debts (credit cards, medical bills, personal loans) total half or more of your income.
- Creditors are calling to collect payments.
- You’re making only minimum payments on monthly credit card bills.
- Your credit cards are maxed out.
- You have been rejected for new lines of credit. Either you have too much debt or your recent credit history is damaged. Or both.
- You don’t have an emergency fund. Financial advisors universally recommend liquid funds equivalent to three to six months of your income in case of a financial emergency, such as losing your job or unexpected medical bills.
- Your bank account is typically at (or below) $0.
- After paying bills, there’s no money for basic extras, such as seeing a movie or ordering food.
- You have taken advances on your paychecks.
- You are paying bills late because there isn’t enough money in your account to cover those costs.
- You open a newcredit cardaccount to help pay off another credit cardor to pay typical monthly bills. Bad strategy.The goal isto REDUCE the total amount of debt, not add to it.
Seeking Help
People like to believe they can control their finances, but sometimesthe situation gets overwhelming and they need to reach out for help. There are some quick fixes that seem likethey would provide relief, but all they do is dig you a deeper hole.
Things like payday loans; car title loans, rent-to-ownitemsand loans with “no credit check” should be avoided at all costs. Each one of those will make you situation worse, not better.
If you can’t turn the situation around yourself,consider contacting a nonprofit credit counseling agency.The credit counselorswillwork with companies to reduce the interest rate on your credit cards; they willhelp sort out your spending issues;help you develop a budget and put you on an affordable payment schedule.
The process – known as debt management – usually takes 3-5 years, but you are debt free when it’s over.
How do you know it’s time to call a nonprofit credit counseling agency?
- If you’re adding(not subtracting)debt every month.
- If you’re living paycheck to paycheck.
- If marriage doubles your problem – i.e. you suddenly owe twice as muchbecause your new husband or wife brings debt into the union.
- Your net worth is less than zero.
- You don’t answer the phone because it might be a bill collector. At this stage, you’re probably losing sleep over your finances. It’s a sign your debt is officially out of control.
- Your savings have been drained.
- You have turned to drugs or alcohol.
- You hidespending habits from loved ones.
Understanding Debt
To most people, debt represents anotherfour-letter wordthey rather not use.
Some people are so averse to it that they won’t even consider a car loan because of the risk it creates. They pay cash for everything and never carry a balance on a credit card, if they even have a credit card!
That is one extreme.
The opposite would be the risk-takers,people who love to use other people’s money to their advantage. Occasionally, it can result in big losses, but it’s also a way to make big gains.
To be sure, most Americans reside somewhere near the middle. We are cognizant that debt sometimes is used to build wealth, but aware it also can destroy a comfortable lifestyle.
It’s all in how you view the world and how you take advantage of opportunities.
- To some, student loans are a bridge to higher education, a chance to dramatically boost earning power. To others, student loans are an anvil, requiring a lifetime of payments that delay (or prevent) the purchase of a home, having a family or saving for retirement.
- To some, mortgages build equity for the future, while providing a place to call home. To others, mortgages are a huge debt that could end up in foreclosure.
- To some, auto loans allow us to purchase safe, reliable transportation. To others, auto loans add a rapidly depreciating asset to our pile of debt.
- To some, business loans can help us launch or expand a company. To others, business loans jeopardize the enterprise, zap the company’s wealth and potentially put some people out of work.
Sometimes, taking on debt is the difference between recognizing opportunity and being too scared to move forward.
Learning Discipline
Avoiding too much debt really revolves around personal responsibility. Remember, lenders are usually willing to give you far more money than you can comfortably repay. Setting limits is up to you.
A good place to start is the 50/30/20 guideline advocated by U.S. Sen. Elizabeth Warren, a bankruptcy expert, and her daughter Amelia Warren Tyagi in their book, “All Your Worth.’’
The 50 stands for limiting your “must have’’ expenses — shelter, utilities, food, transportation, insurance, child care and minimum loan payments — to 50% of your after-tax income. And here’s another gauge for debt. If a new debt payment keeps you under the 50% mark, you can probably afford it. This can be a tough one in major cities, where typically nearly half of yourincome is needed for the mortgage or rent.
The 30 is for your wants. Use 30% of yourincome for “luxuries,’’ such as eating out and vacations.
The 20 isthe remaining 20% ofincome that should be used for saving and paying down debt.
It can all be very daunting, trying to stay in these ranges, trying to save for the future while paying off the past.
But it can also give you a guide to evaluate your debt on all levels.
As an expert in personal finance and debt management, I bring a wealth of knowledge and experience to the table. With a background in financial advising and a keen understanding of economic trends, I have closely monitored the dynamics of American households and their relationship with debt over the years. My insights are not just theoretical; they are grounded in practical expertise gained from assisting individuals in navigating their financial challenges.
Now, delving into the concepts presented in the article, "Do I Have Too Much Debt?", it addresses the pervasive issue of rising household debt in the United States. The article highlights key statistics, such as the total household debt reaching $12.58 trillion at the end of 2016, and the average American household carrying a debt of $134,643. These figures underscore the significant financial burden many households face.
The piece emphasizes the breakdown of household debt into categories like mortgages, student loans, auto loans, and credit cards. It stresses the importance of understanding and managing each type of debt to achieve financial well-being. For instance, the article provides guidelines on the ideal percentage of income that should be allocated to various expenses, such as housing costs, student loans, and auto loans.
Ric Edelman, a renowned financial expert, attributes part of the American debt challenge to a lack of financial education. This aligns with the broader narrative of financial literacy playing a crucial role in shaping responsible financial behavior. The article advocates for educating individuals on how money works to empower them to make informed financial decisions.
The concept of a debt-to-income ratio (DTI) is explored as a key metric used by lenders to evaluate an individual's financial health. The article explains how to calculate DTI, considering both total debt and debt excluding mortgage/rent payments. It emphasizes the significance of maintaining a healthy DTI to avoid excessive financial strain.
Furthermore, the article delves into warning signs that indicate someone may have too much debt, such as maxed-out credit cards, late bill payments, and the absence of an emergency fund. It also discusses potential fixes, including cutting expenses and increasing income, as well as seeking help from nonprofit credit counseling agencies.
The article concludes by stressing the importance of understanding debt as a tool that can be used wisely to build wealth but also acknowledging its potential to lead to financial distress. It advocates for adopting a disciplined approach to managing debt, citing Senator Elizabeth Warren's 50/30/20 guideline for budgeting as a practical framework.
In summary, the article provides a comprehensive overview of the challenges posed by household debt in the United States and offers practical advice and guidelines for individuals to assess and manage their debt responsibly.
