Published in: Banks | May 27, 2019

How Much Debt Is Too Much Debt?

Being in too much debt can get you into trouble -- but exactly how much debt is too much?

Stack of bills labeled past due and account closed

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Being in debt is very common. In fact, most Americans have at least some of kind of debt, whether that’s student loan debt, personal loan debt, credit card debt, mortgage debt, or a combination of different kinds of debt.

Owing some money isn’t necessarily a bad thing. After all, if you fund an education or borrow to start a business or buy a home, those activities should eventually cause your net worth to grow.

But, while it can make sense to take on some debt, you definitely don’t want too much of it, as you could find yourself in a financial disaster. That brings up an important question: Just how much debt is too much?

Being in debt is very common. In fact, most Americans have at least some of kind of debt, whether that’s student loan debt, personal loan debt, credit card debt, mortgage debt, or a combination of different kinds of debt.

Owing some money isn’t necessarily a bad thing. After all, if you fund an education or borrow to start a business or buy a home, those activities should eventually cause your net worth to grow.

But, while it can make sense to take on some debt, you definitely don’t want too much of it, as you could find yourself in a financial disaster. That brings up an important question: Just how much debt is too much?

How much debt is too much?

While it’s OK to borrow some money, you’ve got too much debt if the money you owe is interfering with your ability to accomplish financial goals. If your debt payments are so substantial that you can’t invest for retirement, save for emergencies, or do other things with your money, then you have too much debt.

If you can’t pay your bills at all, this is a clear sign that you’re in over your head and need to deal with your debt problem. However, it’s possible to have too much debt even if you’re able to make your payments if those payments take up too large a percentage of your income.

Most experts recommend keeping your consumer debt, such as credit cards, car loans, and student loan payments below 20% of your monthly take-home pay. When you add in mortgage debt, this number can go higher -- but your debt still shouldn’t take up too much of your take-home pay.

Mortgage lenders typically look at your debt-to-income ratio, which is the total amount of monthly debt payments (including housing costs) relative to your gross monthly income. If this debt-to-income ratio exceeds 43%, you’re considered to be too over-extended and probably won’t get a mortgage.

Finally, when your credit score is calculated by the major credit reporting agencies, your credit utilization ratio is a factor. If you’ve used more than 30% of your available credit, your credit score will be lower because of it.

Remember though, all these ratios are maximums. Many financial advisors would argue that having any high interest debt -- like credit card debt -- is a bad idea because you’re wasting money paying interest on assets that don’t increase in value.

What about good debt?

While credit card debt and other debt for depreciating assets -- such as car loans -- are not great to have, there are some kinds of debt that are considered good debt.

Mortgages and student loans, for example, are both considered good debt because they help you to make an investment in your future. You build equity in your home or earn more money because of your degree, so borrowing makes sense.

Just because student loans and mortgages can help you in the long run doesn’t mean you should borrow an excessive amount of money. It makes no sense to borrow for a home you can’t really afford, as doing so would put you at risk of foreclosure or leave you house-poor and sinking all your money into your home. Similarly, it makes no sense to borrow a ton of money for a degree that won’t lead to a higher salary that allows you to pay back your student loans in a timely manner.

Typically you should keep housing costs to no more than 30% of your income. If your mortgage payments, combined with property taxes and insurance, exceed this amount, you should buy a cheaper house.

As for student loans, you typically shouldn’t borrow more than you expect your annual income to be after graduation. This means if people in your chosen profession make around $40,000 a year, you should cap your loans at no more than $40,000. If you’re looking to go to grad school or med school where your annual income could be higher, then you can borrow more.

Keeping your debt low is always best

Borrowing money always costs money, and the more of your monthly income that goes to paying interest, the less you have to do other things. Whenever possible you should keep your borrowing to a minimum and keep your debt balances low. If you stick to only taking on “good debt” and you keep the amount of good debt reasonable, you’ll be in a much better financial position than if you’ve got big credit card bills to contend with.

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