How much debt is too much? If you can pay it back--eventually--does it matter?
Your doctor recommends coming in for an annual check-up as a preventative measure to help you stay healthy. Your dentist suggests a biannual cleaning to keep your teeth and gums in tip-top shape. Even your mechanic advises stopping in for regular oil changes and tire rotations to help your car go the extra mile. Routine check-ups can mean a healthier you and a longer-lasting vehicle. Your finances are no different.
Whether you're preparing to buy a house, are interested in investing, or simply need to know where you stand financially, regularly monitoring your income and spending is the first step to understanding your debt.
Comparing your earnings against your spending, also known as a debt-to-income ratio, is one of the most popular approaches for evaluating if you have too much debt. Lenders, for years, have looked at debt-to-income ratios to get a better grasp on a person's current financial picture to determine credit-worthiness.
It's a simple way to compare your earnings against your spending. Add up all your monthly debt obligations--credit cards, students loans, mortgage, car payments, and so on. And then figure your monthly net income--that is, after taxes are taken out. Now divide your monthly debt payments by your monthly net--that's your debt-to-income ratio.
Lenders, for years, have looked at debt-to-income ratios to get a better idea about a person's financial picture to determine creditworthiness.
Whenever you anticipate a major credit purchase, or adding a new credit card, check the debt-to-income ratio. Another trigger--when you have a life change such as marriage, new child, job loss, for example. If you're concerned about your credit management, ask someone at your credit union for guidance or for referral to a credit counseling agency.
Your debt-to-income analysis might reinforce your intention to pay down debt. Which is best? Pay down bills with high interest first, or those with a low balance? Consider a few things.
If you have a few bills with small balances--something you can pay off in a few months--pay those first to simplify things and give yourself that sense of accomplishment. Once paid, you can add the amounts you previously paid on those small-balance bills to other debts. Turn your attention to the debts with the highest rates of interest--they cost you the most.
If you don't have any small balances, get to work right away on the high interest debts. We have a calculator that can help you optimize debt payments.
Home & Family Finance® Resource Center
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