How much debt is too much?

There are different types of debt, as well as associated levels of financial strain. Here's how to tell if you're too far in the red.

J Pat Carter/AP/File
A for sale sign lays on the ground in front of a foreclosed home in Homestead, Fla. (March 24, 2009). Florida became a poster child for the housing crisis during the Great Recession.

If you think the answer is simple, you may not understand the question.

That’s often true in life, but particularly so when we’re talking about debt. Simplistic, one-size-fits-all answers actually suit relatively few real people.

At one extreme are those who curse debt as a four-letter word and vow to avoid it entirely. At the other are those who revel in the notion of using “other people’s money” as much as possible.

In the middle live the rest of us, who understand that debt can be a tool to build wealth or destroy it, depending on how we wield it:

  • Student loans can dramatically boost our earning power or strap us to a lifetime of payments that crowd out other goals, including buying a home, having kids and saving for retirement.
  • Mortgages can help us build equity for the future or drag us down into foreclosure.
  • Auto loans can help us buy safe, reliable cars or put us on a treadmill of debt for rapidly depreciating assets.
  • Business loans can help us launch or expand a company — or tank that same enterprise, draining our wealth and putting a lot of people out of work.

So how do we use debt, rather than be used by it?

No one will stop you from taking on too much debt

Start by understanding that lenders will give you far more money than you can comfortably repay. You have to set your own limits and stick to them.

One gauge I like is the 50/30/20 guideline developed by bankruptcy expert and now U.S. Sen. Elizabeth Warren and her daughter, Amelia Warren Tyagi, in their book “All Your Worth.” They recommend limiting your “must have” expenses — for shelter, utilities, food, transportation, insurance, child care and minimum loan payments — to half your after-tax income. That leaves 30% for wants, such as eating out and vacations, with the remaining 20% devoted to saving and paying down debt. If a debt payment you’re considering adding can fit in under that 50% wire, they say, then you can probably afford it.

Keeping to 50% is going to be tough if, as is the case for many people in major cities, nearly half of what you make goes to your mortgage or rent. In Los Angeles, where I live, people spend an average of 47% of their incomes on rent.

But the guidelines also explain why so many people feel so strapped. They simply don’t have enough room in their budgets to do everything that needs to be done, including saving for the future and paying off the past.

How much house is too much? Most mortgages are made under guidelines that cap total debt payments, including housing costs — principal, interest, taxes, insurance and association fees — at 31% to 36% of income, although the limits can be stretched to 45%.

Those limits may have made sense in some misty past, when most people could count on regular pay raises to shrink the relative size of their payments over time. Previous generations paid less for health care and college, plus they didn’t need to save as much for retirement, thanks to shorter lifespans and the greater prevalence of traditional pensions.

Today, with stagnant wages and an uncertain economy, a housing payment that eats one-third or more of your gross income isn’t really sustainable. That doesn’t leave you enough room to save at least 15% of your pay for retirement and still afford your life — particularly if you have student loans or other debt payments and kids you need to educate.

Capping housing costs at 25% of your income can give you the financial flexibility to juggle all the other important financial goals in your life. Also, aim to have your house paid off by the time you’re ready to retire. That means not jumping into another 30-year loan in your 40s, regardless of how great the rates are. Pick the 15- or 20-year mortgage instead.

How much student loan debt is too much? Student loans are another area where people with good intentions wind up in a horrible bind. In general, college students shouldn’t borrow more for a degree than they expect to make their first year out of school. (See “Pick the Best Student Loan Repayment Option.”)

Parents shouldn’t borrow at all, unless they’re able to pay off the loans before retirement age while still being able to save adequately for retirement.

Ideally, your payments should eat up no more than 10% of your gross income.

How much auto debt is too much? Many people take on way too much, as I wrote in “Wonder Why You’re Broke? Look in the Driveway.” Figuring out what’s affordable depends on your other expenses, but most people should try to calculate car payments in the range of 5% to 10% of gross monthly income.

Car loans should be for four years or less and ideally accompanied by a 20% down payment so you don’t spend years owing more than the car is worth.

How much credit card debt is too much? Overspending on any of the above leads many people to rack up credit card debt, and that isn’t smart. Credit cards should be used as a convenience, not a way to finance things you can’t afford out of pocket.

Pay your balances in full every month.

That may seem extreme. It’s not.

A lot of households have no credit card debt at all.  But if you have a balance so big it would take you a year or even longer to pay off, that’s a problem — and it didn’t get there overnight. It began the first month you let the balance roll over.

Any debt like these is too much

Truly toxic debt, to be avoided at all costs, includes:

  • Payday loans
  • No-credit-check loans
  • Title loans
  • Rent-to-own schemes
  • Any other debt that has you paying two or three times over for whatever you’re borrowing (or even more)

What if this advice is coming too late, and you’re drowning in debt? It may be time to seek professional help, in the form of credit counseling or a bankruptcy attorney, if any of the following are true:

  • Your consumer debts — credit cards, medical bills, personal loans — total half or more of your current income.
  • You’re borrowing from one credit account to pay another.
  • You’re being sued over your debts.
  • You’re losing sleep or fighting with a partner over debt.

Debt shouldn’t rule your life. But unless you take charge, it will.

This article first appeared at NerdWallet.

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