The premise of debt is simple: it is a promise by one person to pay another a certain amount, usually under specified conditions.
People generally don't have any problems understanding what debt is, however, most people struggle to know how much is too much.
Set Your Own Limits
The first step in determining where to draw the line on debt is setting your own limits.
When my wife and I went out to get approved for our loan on our home, I was quite surprised to see the amount of money we were "qualified" to borrow on our relatively modest incomes. If I had not gone about calculating some of the ratios below, we would have been tempted to borrow beyond our means. The siren song of a bigger home, in a better neighborhood, with the ability to "wow" our friends and family, is a tough one to ignore.
You need to set aside time and effort to set your own limits, rather than trusting those given to you by a lender. One of the cornerstones of sound financial advice is objectivity, and relying on the very entity that you are trying to borrow from can be a quick path to a poor decision.
How to Know Your Limits
So, how do you go about knowing what your limits should be? The short answer is to simply live well within your means. The longer answer involves a small amount of math.
Housing Ratio #1
This is also referred to as the front-end ratio. This ratio can be used to determine what percentage of your gross income that goes towards housing costs. The formula is as follows:
Total housing costs include your principal, interest, taxes, and insurance (PITI). So, basically your mortgage payment plus the taxes and insurance on your home. Generally, you want this percentage to be under 28%. Leading up to the housing crisis in 2008 and 2009, more and more people had higher front-end ratios, meaning that a mass amount of people had mortgages that they really couldn't afford. This is one reason that the government started to scrutinize these types of ratios in loans to consumers.
Housing Ratio #2
This is often referred to as the back-end ratio. This ratio measures your ability to pay your debts by showing what portion of your income goes towards debt payments. The formula is as follows:
This ratio is essentially a personal debt service ratio. Generally, you want the ratio listed above to be less than 36%. This ratio, I would argue, is the most important ratio of the two for planning purposes because it accounts for ALL your debt. Going by this ratio, you can assure that your total level of debt stays manageable. If you have more debt in one area, you know that you can afford less debt in other areas.
Lenders use both ratios above when approving borrowers for loans, but BEWARE, just because a lender approves you for a loan, that doesn't mean that you can afford it! Lenders will often use percentages much higher than the ones listed above in their criterion for approving borrowers.
The ratios above are not targets to shoot for, but rather upper limits to stay under.
What If You've Exceeded Your Limit?
If you are currently living beyond your means, you have two options: 1.) Earn more, or 2.) Spend less. Since option #1 isn't usually an option for most people, option #2 is likely the solution. It's a simple solution with some seriously hard decisions.
If you meet one of the following debt danger signs, it may be time to seek some professional help:
- You struggle to make the minimum payments on your debts, possibly juggling which debt you even pay at all each month.
- You've been tempted to take, or have taken, a cash advance or a payday loan to meet your debt obligations.
- Your debt payments are over half of your income.
- You have to cash out retirement savings to pay debts.
- You consistently lose sleep over your indebtedness.
Too many people look for financial gurus, books, and podcasts for easy solutions to their money problems while ignoring the hard truth that they are living beyond their means. Debt can easily consume your life if you are not mindful of it.
My son, don’t make yourself responsible for the debts of others. Don’t make such deals with friends or strangers. If you do, your words will trap you. You will be under the power of other people, so you must go and free yourself. Beg them to free you from that debt. Don’t wait to rest or sleep. Escape from that trap like a deer running from a hunter. Free yourself like a bird flying from a trap.
-Proverbs 6:1-5 (ERV)