How Much Debt is Too Much? Guidelines for Managing Debt
Do you want to have a new car, a new home, luxury vacations, a great wardrobe, a big screen TV and maybe some nice toys or expensive jewelry? Who doesn't? There's nothing wrong with having these things as long as you can afford them. But what if you want them now and you think you can "afford" the payments? That's the million dollar question - when are you in over your head with too much debt? Even if you can manage your payments, at least for now, you may be heading for trouble. Here are three ways to tell if you're close to being maxed out or to being turned down the next time you want to borrow:
What the Banks Say is Too Much
Here is how the bank looks at your debt: when you add up all of your monthly debt payments along with heating and taxes for your house, this number should not exceed 40% of your income. So when you add up your monthly credit card payments (if you don’t pay them off in full each month), line of credit payment, car payment, mortgage payment and payments for heat and taxes, the total of all of these payments should not exceed 40% of your monthly income (before taxes). Lenders call this your Total Debt Servicing Ratio (TDSR). If your TDSR is 40% or greater, they will not lend you any more money (there are some very small exceptions to this rule that aren’t worth mentioning here. Your banker will consider using them if they apply to your situation).
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Banks also will not give you a mortgage if your Gross Debt Servicing Ration (GDSR) exceeds 32%. GDSR is the ratio of your “shelter costs” (housing costs) to your income. Your GDSR is your mortgage payment plus heating and taxes. So this means that banks will not lend you money if the cost of owning your home exceeds 32% of your income.
There are some subprime lenders (finance companies who lend at higher interest rates than the banks) who will lend to people with TDSRs that exceed 40%, but this is often not a very good idea. Anyone who is using 40% of their income to pay their debts and is surviving and paying taxes out of the remaining 60% is generally forced to live a very frugal life. Most people do not like to live this frugally, but it is necessary if you choose to borrow the maximum amount of money that the banks will lend you. The best idea is to borrow according to what your budget says you can afford rather than what the bank will permit.
When you put together your personal budget, you can figure out the minimum amount of money that you need to live a lifestyle that is acceptable to you. When you do this, you can then see what the maximum amount of debt is that you can afford to make payments on. Figuring this out for yourself is one of the smartest things you can do for your finances. Once you do this, when your banker, mortgage broker or credit card company offers you more money, you can politely decline their offer because you know that you cannot afford more debt without making some sacrifices.
Banks, mortgage brokers and credit card companies will often offer you bigger loans and higher credit limits if you meet their lending criteria, but they don’t know your budget. They don’t know that lending you just a little more money may begin to make life difficult for you. When you think about it, you can see that you actually make life harder for yourself by not doing your homework and knowing what you can afford. Creating a budget tells you what you can afford. Make the smart choice and put together a budget if you haven't already. You can click here to learn how to make a budget.
Related: Try out our free Interactive Budgeting Spreadsheet. It tells you if you have too much debt plus it lets you know if you're spending too much in other areas of your budget
If you are wondering if you have too much debt, you probably do. However, the easiest way to figure out if you have too much debt is if more than half of your income goes to paying your debts. If this is true for you, then you are quite possibly in over your head, and you need to do something about this quickly. If you are using more than half of your income to pay your debts and you think you still have your situation under control, you may be fooling yourself. Check out the warning signs to see how close you are to the edge. If you know that you are on the edge, click here for some solutions.