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As many as 65% of Americans are currently paying interest on credit card debt, a sure sign that many households have way too much debt.

But just how much debt is too much is subjective, and the answer depends on variables that include your gross income, other monthly bills, and the debt payments you are required to make each month. Below, we'll use a calculator, a strict rule, and borrow a formula from the banking industry to determine if you have too much debt.

1. A simple ratio

No ratios are perfect, but a simple one that some use is that your monthly debt payments plus rent or mortgage payments should not exceed 45% of your monthly income after taxes. The calculator below uses this rule to determine if you have too much debt.

 

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

The calculator assumes that your required monthly payments are equal to 2% of your non-mortgage balances, which is a good approximation for car loans and credit cards. It might not be a good assumption for other obligations like student loans, however. See if you pass the next two tests.

2. A strict rule: Do you have any unsecured debt?

Unsecured debt is debt that isn't secured by collateral. For example, credit cards and personal loans are unsecured debts, because there is no collateral that backs the loan. Conversely, mortgages and car loans are secured debts, because they are backed by a home or automobile.

Lenders charge higher interest rates on unsecured debt because it is inherently risky. If you don't pay your mortgage, the bank can repossess your home, sell it, and recoup most of what you owe. If you don't pay your credit card bill, the bank has no collateral to repossess. At best, it can sue you (a costly process), and hope to recover a small percentage of what you actually owe after all the legal fees and collection costs.

Frankly, if you have unsecured debt, you probably have too much debt. According to government data, the average balance on a credit card carried an interest rate of about 13.8% in August 2016. Personal loans carried an average rate of about 9.6%. These rates are more than 3 times higher than average car loan rates, and four times higher than a reasonable mortgage rate.

No, having unsecured debt won't necessarily tank your credit score or prohibit you from qualifying for a low rate on a mortgage or student loan. But if you have unsecured debt, it's likely because you are, or have, borrowed for routine expenses in the past. Take it as a sign that you need to reevaluate your budget, and prioritize paying down your balances as quickly as you can.

This rule isn't particularly fun, but the next one is. Let's look at your finances through the lens of the banking system to see if you have too much debt.

3. The banking industry's rule on debt vs. income

Lenders use so-called "rules of thumb" to determine if borrowers can manage their required monthly debt payments. We can adopt a rule of thumb used by the banking industry to determine if you have too much debt relative to your income.

The rule of thumb we'll be using is called the "back-end ratio," which compares routine monthly payments you must make on all your debts to your gross (pre-tax) income. To calculate your back-end ratio, you'll need a few pieces of information.

  1. Monthly rent or your monthly mortgage payment plus property taxes and insurance.
  2. Car payments.
  3. Student loan payments.
  4. Credit card, personal loans, and other debts with required loan payments.
  5. Child support payments.

Simply add up these monthly minimum payments and then divide by your monthly gross income. For example, if all of your required payments add up to $1,800 per month, and your gross income is $5,000, your back-end ratio is $1,800 divided by $5,000, or 36%.

Lenders typically require a back-end ratio of 36% or less. First-time home buyers who make use of FHA financing are given more breathing room, and can have a back-end ratio as high as 43%. Your odds of a rejection letter increase substantially with each percentage point over the 36% and 43% limits.

I like this rule because it takes your largest monthly expenditures into consideration, and because history has shown that it works. In fact, you could argue that the housing boom and resulting bust of the 2000s happened precisely because lenders stopped using this ratio to qualify borrowers.

Getting smart about your finances

Some of these rules (No. 2, in particular) were purposefully included to get you to think about how much you owe in a different light. Just because you can afford the payments on $15,000 of credit card debt doesn't mean that you're in good financial shape. Similarly, you can't look at your debt payments in a vacuum, and ignore your income, or other routine expenditures.

Having a lot of debt is not the end of the world. Higher balances and payments can be very manageable if you're willing to make small sacrifices along the way. Remember that if you have debt, every dollar you don't use to pay down your debt is effectively another dollar borrowed. With that in mind, it's a lot easier to make the changes you need to free yourself from the burden of monthly payments. 

 

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