In the beginning there was bartering. It was a pretty good system, such as it was. If I had an abundance of something valuable, I could trade it for something I didn’t have. I’ve got goats, you’ve got textiles – let’s do a little business here.
But goats (and wool and cabbages and axe heads) are a very inexact sort of currency. And not everyone wants or needs goats. So we created money – simple, pocket-sized markers that represented the objective value of all those goats and cabbages and such.
Once we figured out money, we figured out how to borrow money. Not too long after that, we figured out that we could charge people money for the privilege of borrowing money. And that, in an exceptionally condensed nutshell, is where debt was born.
Working for a credit counseling agency, I spend a lot of time and energy helping people get out of debt. For a lot of consumers, debt has overwhelmed their finances and their lives. It informs every decision they make. It’s a source of constant fear and anxiety. For some people, debt has literally ruined their life.
But debt itself isn’t bad. It’s certainly not evil. In fact, debt is a perfectly normal part of personal finance. It’s a tool – one that can help you or hurt you, depending on how it’s used. The trouble only really begins when debt crosses that threshold from healthy to unhealthy. So how exactly do you know when your debt is verging into troubling territory?
The Eye Test
There are two simple ways to approach the question. One of them involves math and the other one doesn’t. We’ll do the non-math one first.
Does your debt feel restrictive? If you feel like you have too much debt, it’s fair to say that for your personal comfort levels, you probably do. If your budget is tighter than you’d like or you’ve got a growing concern about your ability to meet certain financial responsibilities, you should take a hard look at your debt levels and consider possible action steps to relieve your debt load.
Here’s how you can use math to understand your debt issues.
The average US household carries $15,611 in credit card debt, $155,192 in mortgage debt, and $32,264 in student loan debt.
That doesn’t really say much about your specific situation, though, so a better measure of the relative health of your debt load is your debt-to-income ratio.
Debt-to-income is a pretty straightforward formula: just divide your monthly debt payments (mortgage, car loan, credit card payments, etc.) by your gross monthly income. A debt-to-income ratio above 36 percent is a red flag. According to the Consumer Financial Protection Bureau, a ratio above 43 percent will almost certainly disqualify you from receiving a qualified mortgage.
As your debt-to-income ratio climbs, you run an increasing risk of tipping past the point where your income can sustain your debt. Lenders will be very wary of lending you further money, while your debt payments will begin to overwhelm your budget. In other words, you’ll find yourself in a hole you’ll be hard-pressed to dig yourself out of.
If you’ve run the numbers and they don’t look good, the next step should be to analyze your debt and pick a point of attack.
Debt – The Good, the Bad, and the Neutral
First, let’s make a distinction between “good debt” and “bad debt”. Any debt that improves the quality of your health or happiness could be considered a “good debt”, but here we’re really considering the possible positive and negative financial impact of different loan types.
The best kind of debt is one where the value returned exceeds the cost. A mortgage is usually considered a good debt, because in addition to providing you with shelter (and who doesn’t love shelter?), your house has a very good chance of increasing in value over time. At a minimum, your house will very likely retain a large percent of its value.
Even if you aren’t flipping it for a potential profit, buying a home is usually a good investment (assuming you’ve done your due diligence), and assuming 30 years of debt for the mortgage is a perfectly healthy component of a long-term financial plan.
Similarly, student loan debt is considered to be an investment in many ways. Leaving aside the difficulty that many recent graduates are facing paying back these loans, it’s hard to argue against the impact a college degree has on your potential earning ability. Adults without a college degree are almost twice as likely to be unemployed as those with a degree, while graduates, on average, earn almost twice as much money as non-graduates.
Mortgages, student loans, and small business loans are essentially life investments. They cost you money, but they have the potential to return that money to you over time. As a bonus, they usually come with manageable interest rates, meaning they cost you less on a per dollar basis than almost any other debt you might carry.
Unlike your house, your car will not increase in value. It won’t even hold its value. In fact, your car will decrease in value, sharply and immediately.
That doesn’t necessarily make your car loan a bad debt. It’s still a secured debt at a (hopefully) reasonable interest rate. Unless you’re an Uber driver, however, it’s unlikely that your car is making you money, which is why it isn’t a good debt either.
Medical debt also falls into the neither good, nor bad category. If you’ve worked out a repayment plan with your health care provider, you probably aren’t paying any interest, which at least mitigates some of the financial damage. If you were talked into opening a special credit card account for your medical debt, however, then your medical debt is really just another credit card debt, and credit card debt falls into the next category.
Your remaining unsecured debts are your bad debts – at least in relation to all your other debts. This is the debt that costs you money and doesn’t even pretend like it’s going to help you make that money back. If you’re feeling a financial pinch, your credit cards, store cards, and other unsecured debts are probably where any potential debt-shedding plan should begin.
Debt versus Savings
If your debt passes the eye test and your debt-to-income ratio is on the right side of the curve, you should still take some time to consider what your debt is costing you.
For each individual debt, multiply the amount currently owed by the annual percentage rate. This will give you a rough estimate of how much that debt will cost you for the year. A credit card with a $7,000 balance and a 12 percent APR, for example, will cost you about $840 for the year.
Now consider the return you’re getting in various savings and investment platforms. You should always have an adequate emergency savings account, but savings accounts in general have a pretty low rate of return. If you’re trying to decide between saving money and paying down debt, weigh the cost of your debts against potential earnings to determine the best use of your money. Sometimes the best return on investment is simply paying off debt and avoiding future costs.
Of course, finding the best return on investment isn’t the only factor to consider when it comes to financial planning. Big goals and impending life events should also play a role in dictating where you allocate your money.
Everything in Balance
Being in debt is no cause for alarm. Being slightly too far in debt, however, is a sign that you should probably put some focus on debt reduction. Keeping your debt at a healthy level is absolutely crucial to maintaining your financial equilibrium.