Debt is complicated. Sometimes, taking on debt seems like a good idea, say when you get a mortgage to buy a home or use student loans to pay for your education. Both can potentially help you grow your net worth.
On the other hand, it can quickly turn negative, when you get stuck with high interest rates or borrow money to pay for things you can’t truly afford.
Unfortunately, it can be tough to know the difference between good and bad debt at times, since anyone with a good credit score, stable income and positive payment history can usually get a new credit card, take out a personal loan or buy a car with no money down.
With so many opportunities to finance items, today’s consumers need to be savvy. To help you discern just how much debt you can actually handle (and why), we spoke to certified financial planner and Albert head of advice, Vadim Verdyan.
Ahead, Verdyan shares with Select a few key factors to consider if you’re trying to figure out if you can actually afford more debt.
How to determine your debt tolerance
- Calculate your debt-to-income ratio.
- Watch your credit utilization.
- Add up the total cost of the debt.
- Assess your personal comfort level.
Calculate your debt-to-income ratio
It’s almost impossible to guess whether someone can afford a new loan or an increased credit limit based on how much they make in income alone because different people will have different living expenses. Lenders use a standardized calculation called debt-to-income ratio (DTI) to gauge whether a loan applicant has room in their budget to borrow more money.
DTI is calculated by comparing your monthly debt payments to your total monthly income. The equation includes housing costs (whether you rent or own) and any other minimum payments on outstanding debts of any kind.
For example, say your rent/mortgage, plus the minimum monthly payments on your credit cards, student loan payments, personal loans and car loans totals $2,000 and your gross monthly income is $4,000, your DTI calculation would look like: $2,000 / $4,000 = 0.5. To get the ratio as a percentage, you would then multiply 0.5 x 100 = 50%. Your DTI would be 50%.
An ideal DTI is no more than 36%, says Verdyan, though some qualified mortgages are available to borrowers with DTIs as high as 43%. Lenders typically use your gross, or pre-tax, income to calculate your DTI, but Verdyan advises against that when you do your own personal calculation.
“I always recommend people gauge DTI off of their net income,” he says. “Think about it: You’re not going to be using a big portion of your paycheck since it’s going to taxes, social security, health insurance and so on. [Using gross income] doesn’t really give you a realistic picture of your actual budget.”
If you’re looking to take out a loan, make sure that your monthly bill won’t exceed 36% of your take-home pay. If you want to be more conservative, don’t go above 30%. That way you’ll have at least 70% of your paycheck leftover to cover the rest of your bills as well as any discretionary spending plus some cash free to save for future expenses.
Watch your credit utilization
If you’re thinking about putting a big purchase on a credit card, like a 0% APR card, with a plan to pay it off over several months, don’t forget about your credit-utilization rate (CUR).
Credit utilization looks at how much you owe versus your credit limits across all credit cards. If you have, for example, three cards, each with a $3,000 credit limit, your total credit limit is $9,000. A $3,000 purchase would equal one-third of your total credit utilization, so your CUR would be 33%, until you pay it off.
It’s not always a bad idea to charge big items to a credit card, especially if you can take advantage of 0% financing and/or meet the minimum spending requirement to earn a generous welcome bonus.
But charging a big-ticket item is going to temporarily raise your CUR and cause your credit score to drop. Once you pay the balance off, your score will improve. But you shouldn’t raise your CUR right before applying for a new apartment or even while searching for a new job, since you’ll want your credit score to be good shape in case a credit check is part of the application.
“We recommend your credit utilization be 30% or less,” says Verdyan. Other experts suggest even lower, recommending your CUR be 10% or less.
But since credit cards generally charge a higher interest rate compared to a personal loan or home equity line of credit, it’s not always the best financial decision to spend above 30% of your credit limits just because it’s available.
Add up at the total cost of the debt
The more you money you borrow, the more you’ll pay in interest charges and fees. Always review the interest rates on any kind of credit or loan product before you apply. Break it down into monthly, or even daily, fees, to get perspective as to just how much your debt truly costs. Also look for hidden costs like origination fees, early payoff penalties and more.
If you’re taking out a mortgage, or even refinancing a sizeable student loan, use an interest calculator to see how much you’ll pay in interest over the lifetime of the loan. Try to improve your credit score before applying to borrow any type of product so that you can qualify for the best rate and save.
Assess your personal comfort level
Putting aside the financials, you also want to take time to consider your personal feelings about money, borrowing and debt.
There’s an old saying: “Have a plan and work the plan.” Some people know instinctively that they are savers, meaning they don’t buy anything until they have enough cash in the bank to cover it. Others know they won’t lose sleep if they have some outstanding debt.
Psychologists could debate (and probably have) for ages about what makes certain people more risk averse than others. But for your wallet’s sake, it’s worth thinking about where you fall on the spectrum from “saver” to “spender.”
When making a decision about taking on more debt, you’ll also want to think about where you are in life at this moment, and where you want to be several years from now. Someone in their 20s can arguably afford to take more risks when it comes to borrowing and investing, since they have more time to correct their course if they make a few mistakes along the way.
But just because you can afford to take risks doesn’t mean you should be all-out reckless. If you do decide to take on more debt, you should always have a plan to pay it off. And then stick to that plan.
Whether it’s borrowing student loans, using a 0% APR credit card to finance a major purchase, taking out a personal loan to pay for an online certification or anything else, it’s important to see how these additional payments will impact your budget and consider the long-term costs before you commit to taking on more debt.
