How Much Debt is Too Much?

How Much Debt is Too Much?

We all know less debt is better than more, right? There are many reasons, but five that come to mind for me are:

  1. Less Hassle. Why spend time paying tons of creditors each month, if you don't have to?
  2. Less Worry When Things Turn Bad. As we've seen with the worldwide pandemic, many families have suddenly needed to get by on less income. When you have no debt, this is much easier.
  3. It Just Feels Great Not to Owe Anyone. I think everyone can agree on this!
  4. More Money For Other Goals. Less money going out to creditors in the form of monthly payments means more money to put into your own savings account for goals like vacation, retirement, a new home, or whatever you're saving up for!
  5. An Improved Credit Score. This one is a biggie. Let's dig a little deeper here. A good credit score allows you to borrow money at much lower rates than if you have a poor credit score. And if your credit score is really low, you may not be able to borrow at all. For example, this is particularly important when considering a home loan. Since mortgages are typically long term loans (15-30 years), your interest rate matters a whole lot.

So, how do you determine how much debt is okay? Your credit utilization ratio is one way to look at it. Generally, a credit utilization ratio of 30% or below is what you're aiming for. This means you're using 30% (or less) of the credit available to you. Credit utilization ratio is a significant factor in most credit scoring models, meaning it's important to know yours, and realize that it impacts your credit score. To find your ratio, simply add up the balance on all your debts. Then, divide that number by the total credit limits on all your cards and loans. The resulting number is your credit utilization ratio. Here is an example:

Total of All Debt/ Total Available Credit= Credit Utilization Ratio
$4,200/ $10,000 = 42%

As the saying goes, knowledge is power, and the more we can know about our own financial lives, the easier it is to make any necessary changes.