How Much Debt Is Too Much?

The premise of debt is simple: it is a promise by one person to pay another a certain amount, usually under specified conditions.

People generally don't have any problems understanding what debt is, however, most people struggle to know how much is too much.

Set Your Own Limits

The first step in determining where to draw the line on debt is setting your own limits.

When my wife and I went out to get approved for our loan on our home, I was quite surprised to see the amount of money we were "qualified" to borrow on our relatively modest incomes. If I had not gone about calculating some of the ratios below, we would have been tempted to borrow beyond our means. The siren song of a bigger home, in a better neighborhood, with the ability to "wow" our friends and family, is a tough one to ignore.

You need to set aside time and effort to set your own limits, rather than trusting those given to you by a lender. One of the cornerstones of sound financial advice is objectivity, and relying on the very entity that you are trying to borrow from can be a quick path to a poor decision.

How to Know Your Limits

So, how do you go about knowing what your limits should be? The short answer is to simply live well within your means. The longer answer involves a small amount of math.

Housing Ratio #1

This is also referred to as the front-end ratio. This ratio can be used to determine what percentage of your gross income that goes towards housing costs. The formula is as follows:

Total housing costs include your principal, interest, taxes, and insurance (PITI). So, basically your mortgage payment plus the taxes and insurance on your home.  Generally, you want this percentage to be under 28%. Leading up to the housing crisis in 2008 and 2009, more and more people had higher front-end ratios, meaning that a mass amount of people had mortgages that they really couldn't afford. This is one reason that the government started to scrutinize these types of ratios in loans to consumers.

Housing Ratio #2

This is often referred to as the back-end ratio. This ratio measures your ability to pay your debts by showing what portion of your income goes towards debt payments. The formula is as follows:

This ratio is essentially a personal debt service ratio. Generally, you want the ratio listed above to be less than 36%. This ratio, I would argue, is the most important ratio of the two for planning purposes because it accounts for ALL your debt. Going by this ratio, you can assure that your total level of debt stays manageable. If you have more debt in one area, you know that you can afford less debt in other areas.

Lenders use both ratios above when approving borrowers for loans, but BEWARE, just because a lender approves you for a loan, that doesn't mean that you can afford it! Lenders will often use percentages much higher than the ones listed above in their criterion for approving borrowers.

The ratios above are not targets to shoot for, but rather upper limits to stay under.

What If You've Exceeded Your Limit?

If you are currently living beyond your means, you have two options: 1.) Earn more, or 2.) Spend less. Since option #1 isn't usually an option for most people, option #2 is likely the solution. It's a simple solution with some seriously hard decisions.

If you meet one of the following debt danger signs, it may be time to seek some professional help:

  • You struggle to make the minimum payments on your debts, possibly juggling which debt you even pay at all each month.
  • You've been tempted to take, or have taken, a cash advance or a payday loan to meet your debt obligations.
  • Your debt payments are over half of your income.
  • You have to cash out retirement savings to pay debts.
  • You consistently lose sleep over your indebtedness.

Too many people look for financial gurus, books, and podcasts for easy solutions to their money problems while ignoring the hard truth that they are living beyond their means. Debt can easily consume your life if you are not mindful of it.

My son, don’t make yourself responsible for the debts of others. Don’t make such deals with friends or strangers. If you do, your words will trap you. You will be under the power of other people, so you must go and free yourself. Beg them to free you from that debt. Don’t wait to rest or sleep. Escape from that trap like a deer running from a hunter. Free yourself like a bird flying from a trap.

-Proverbs 6:1-5 (ERV)

How to Determine Which Debt to Pay Off First

The average American household has $98,315 in debt. If you remove all of the people who are debt free, the average household with debt has $132,086 in debt (Nerd Wallet).

How does your debt rank with the average American? Does it make you feel better? Worse?

Before we get into specific debt repayment strategies we need to understand the basic process of paying off debts in general. The basic steps to approach paying off your debt are:

  1. Pay the minimum payment on all your debts. This one is not optional. Not paying at least the minimum payment on all your debts equals much more trouble down the road. This is where you can consider debt consolidation and other forms of restructuring if need be.
  2. Track your spending. Know where your money is going each and every month. Here is a list of 12 free apps to help (I use Mint).
  3. Cut your spending. If you've successfully tracked your spending, it's inevitable that you'll find something that appalls you. When my wife and I tracked our spending for the first time we couldn't believe how much we were spending each month on eating out. Find these areas and cut back.
  4. Budget. Now that you know where your money has been going, it's time to plan for where it should be going. Here's some info on how to get started. In doing your budget, determine how much you can allocate to debt repayment above the minimum payments.
  5. Choose a payoff strategy and allocate accordingly. This is where the jury seems to be out on what to do. Many people have multiple sources of debt and have to decide the best way to pay them all off. There are many strategies paying off debt from various sources, but three strategies consistently rise to the top in terms of people implementing them.

So what are the three methods, and which is right for you?

Strategy 1: The Balance Method (Debt Snowball)

This strategy was made popular by Dave Ramsey and has garnered multitudes of followers that are loyal to Dave and his sage wisdom for the masses. This method is defined by ranking all of your debt by the size of the debt. From there you still pay the minimum payment on all your debts, but you allocate everything else that you can towards paying off the smallest balance first. Then moving on to the next smallest, and so on.

Trent Hamm wrote a great article on his thoughts on the Dave Ramsey snowball approach, and you can find it here. Like Hamm, I greatly respect and admire what Dave Ramsey has done for many, many people, but you have to keep in mind that he is speaking to a very broad audience and has to make some generalizations.

The snowball method is deeply rooted in psychology. It uses the feeling of accomplishment that comes with having a debt eliminated from your plate entirely to fuel your motivation to eliminate the rest. The reason this method is called the "snowball effect" is that when you eliminate one debt, you allocate all your money that you were paying towards eliminating that debt towards the next debt in line, increasing the amount you are paying on each successive debt balance.

Strategy 2: The Interest Rate Method

In this method, you still pay the minimum payment on each debt, but the difference is that you rank each debt by the interest rate, rather than balance, associated with it. In this method, you still "snowball" the amount you had been paying on prior debts, but the process doesn't always happen as quickly since the lowest balance debt is not always prioritized first.

Logically and mathematically speaking, this method is proven to lead to the least amount paid over the life of all your debts of any approach.

The reason behind this? Your interest rate on your debt is the cost at which the money is borrowed. The longer your highest interest debt stays active, the more and more interest that you accumulate over the life of the loan (and this isn't the good kind of interest like from your investments). By focusing on high-interest rate debt first, you minimize the impact these rates have on how much you end up paying. Compound interest is a powerful thing, either working for or against you.

So if this method is mathematically the best, why doesn't everyone use it?

Psychology. Some people drive home on a route that they know to be slower than other ways, but they enjoy the drive of the slower route more. In the same way, some people may know that they will be paying more for their debt in the long-run, but like the feeling of having one less bill in the mail. Comfort always comes at a cost. In the driving metaphor the cost is time, and in regard to debt, it's usually money (and often time).


Comfort always comes at a cost.


 Strategy 3: The Credit Limit Method

This strategy is my least favorite out of the three, so I will spend the least amount of focus on it. The difference in this strategy is ranking your debts by their credit limit. Naturally, your credit cards (lower credit limits) usually rise to the top in this method and your debts like your home and student loans (indefinite credit limits) fall to the bottom. This method is geared towards building and protecting your credit by trying to keep your credit utilization rate at the lowest possible. Your utilization rate is the amount of debt that you have compared to your total allowable limit.

The reason that I am not as big of a fan of this method is that it ignores the cost of borrowing money (your interest rates) and focuses on setting you up the best to borrow again in the future. This seems like the equivalent of breaking your arm in a downhill skiing accident and asking the doctor to put a less-than-optimal cast on your arm so you can compete in an even more dangerous event next year. This method may help you to get a better interest rate in the future, but I'm all for debt reduction strategies that get to the root of the problem: unnecessary spending and living beyond your means.


Debt reduction is all about living within your means and eliminating habits of uncontrolled spending.


So, Which Method Is For Me?

If you want to pay off your debt in the most efficient way possible and have the discipline to pay off your debts with the highest interest rate first, even if they don't have the lowest balance, then the Interest Rate Method is likely the best way for you. This way will lead to you paying the least amount over the life of all your debts and is typically my recommendation to people.

If you are not as disciplined or have a hard time making a plan and sticking to it, then the Snowball (Balance) Method might be the best for you. This way helps you to have some smaller "wins" earlier on that can help motivate you to continue.

If you're concerned with your credit score and really want to focus on keeping it as high as possible, then the Credit Limit Method is the best way for you. The method will lead to the fastest decrease in your credit utilization and should help your credit score most readily.

There is not necessarily a one-size-fits-all answer to this question and it is important to consider your goals and personality before drawing up a debt repayment plan. Feel free to reach out with any questions or help with developing a debt game plan of your own.




American Household Credit Card Debt Statistics: 2015
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In What Order Should I Pay Off My Debts?