Is it time to worry about your debt?

As a credit counseling agency, we spend a lot of time and energy helping people get out of debt. For a lot of consumers, debt has overwhelmed their finances and their lives. They think about their debt daily. It plays a part in every decision they make. It’s a source of constant fear and anxiety. For some people, debt literally controls their life.

But debt itself isn’t bad. It’s certainly not evil. In fact, debt is a perfectly normal part of personal finance. It’s a tool – one that can help you or hurt you, depending on how it’s used. The trouble only really begins when debt crosses over from a healthy level that you can manage to an unhealthy level that cannot be managed. So when should you start to worry about your debt?

The Eye Test

There are two simple ways to approach the question. One of them involves math and the other one doesn’t. We’ll do the non-math one first.

Start by asking yourself a simple question: how do you feel about your debt? Does your debt feel restrictive? Are you worried about it? If you feel like you have too much debt, it’s fair to say that for your personal comfort levels, you probably do.

Beyond a simple gut feeling, are you having a hard time meeting your monthly financial obligations? Have you been late on any payments because your due date was on the wrong side of your next payday? If your budget is tighter than you’d like or you’ve got a growing concern about your ability to keep everything in balance, you should take a hard look at your debt and start thinking about possible next steps to take some of the pressure off.

Debt-to-Income Ratio

The average US household carries $15,611 in credit card debt, $155,192 in mortgage debt, and $32,264 in student loan debt.

That doesn’t really say much about your specific situation, though, so a better measure of the relative health of your debt load is your debt-to-income ratio.

Debt-to-income is a pretty straightforward formula: just divide your monthly debt payments (mortgage, car loan, credit card payments, etc.) by your gross monthly income. A debt-to-income ratio above 36 percent is a red flag. According to the Consumer Financial Protection Bureau, a ratio above 43 percent will almost certainly disqualify you from receiving a qualified mortgage.

As your debt-to-income ratio climbs, you run an increasing risk of tipping past the point where your income can sustain your debt. Lenders will be very wary of lending you further money, while your debt payments will begin to overwhelm your budget. In other words, you’ll find yourself in a hole you’ll be hard-pressed to dig yourself out of.

Debt versus Savings

If the signs seem to indicate that your debt is verging on unmanageable levels, it may be time to start making a concerted effort to reduce your debt.

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However, if your debt passes the eye test and your debt-to-income ratio is on the right side of the curve, you should still take some time to consider what your debt is costing you.

For each individual debt, multiply the amount currently owed by the annual percentage rate. This will give you a rough estimate of how much that debt will cost you for the year. A credit card with a $7,000 balance and a 12 percent APR, for example, will cost you about $840 for the year.

Now consider the return you’re getting in various savings and investment platforms. You should always have an adequate emergency savings account, but savings accounts in general have a pretty low rate of return. If you’re trying to decide between saving money and paying down debt, weigh the cost of your debts against potential earnings to determine the best use of your money. Sometimes the best return on investment is simply paying off debt and avoiding future costs.

Of course, finding the best return on investment isn’t the only factor to consider when it comes to financial planning. Big goals and impending life events should also play a role in dictating where you allocate your money.

Everything in Balance

Being in debt is no cause for alarm. Being slightly too far in debt, however, is a sign that you should probably put some focus on debt reduction. Keeping your debt at a healthy level is absolutely crucial to maintaining your financial equilibrium.

Jesse Campbell is the Content Manager at MMI, focused on creating and delivering valuable educational materials that help families through everyday and extraordinary financial challenges.

  • The Consumer Federation of America (CFA) is an association of nonprofit consumer organizations that was established in 1968 to advance the consumer interest through research, advocacy, and education. Today, nearly 300 of these groups participate in the federation and govern it through their representatives on the organization's Board of Directors.

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  • The National Foundation for Credit Counseling® (NFCC®), founded in 1951, is the nation’s largest and longest-serving nonprofit financial counseling organization. The NFCC’s mission is to promote the national agenda for financially responsible behavior, and build capacity for its members to deliver the highest-quality financial education and counseling services.