How To Determine Your Debt Tolerance

Written by: Ashley Perlmutter

Debt can be a helpful tool in achieving your dreams and even building wealth, but it’s important to know how much you can comfortably handle. Debt can be complicated. Sometimes, it seems like taking on debt is a good idea, because you want to help grow your net worth and start building up your credit. However, building up debt can be a slippery slope and quickly turn negative, especially when you get stuck with high interest rates or borrow money to pay for things you truly cannot afford. 

Unfortunately, it can be tough to know the difference between good and bad debt at times, since anyone with a good credit score, stable income, and positive payment history usually gets approved to take on more debt with no money down. With so many opportunities to take on debt and finance items, it’s important to be savvy and have a system in place to know when and when not to take on more debt. Today we want to point out a few key factors to consider if you are trying to figure out if you can afford more debt 

  1. Calculate your debt-to-income ratio
  2. Watch your credit utilization 
  3. Add up the total cost of debt
  4. Assess your personal comfort level

Calculate your debt-to-income ratio

It’s almost impossible to guess whether someone can afford a new loan or an increased credit limit based on how much they make in income alone because different people will have different living expenses. Lenders use a standardized calculation called debt-to-income ratio (DTI)  to gauge whether a loan applicant has room in their budget to borrow more money. DTI is calculated by comparing your monthly debt payments to your total monthly income. The equation includes housing costs (whether you rent or own) and any other minimum payments on outstanding debts of any kind.

If you’re looking to take out a loan, make sure that your monthly bill won’t exceed 36% of your take-home pay. If you want to be more conservative, don’t go above 30%. That way you’ll have at least 70% of your paycheck leftover to cover the rest of your bills as well as any discretionary spending plus some cash free to save for future expenses.

Watch out for your credit utilization 

If you’re thinking about putting a big purchase on a credit card, like a 0% APR card, with a plan to pay it off over several months, don’t forget about your credit-utilization rate (CUR).

It’s not always a bad idea to charge big items to a credit card, especially if you can take advantage of 0% financing and/or meet the minimum spending requirement to earn a generous welcome bonus. But charging a big-ticket item is going to temporarily raise your CUR and cause your credit score to drop. Once you pay the balance off, your score will improve. But since credit cards generally charge a higher interest rate compared to a personal loan or home equity line of credit, it’s not always the best financial decision to spend above 30% of your credit limits just because it’s available.

Add up at the total cost of the debt

The more money you borrow, the more you’ll pay in interest charges and fees. Always review the interest rates on any kind of credit or loan product before you apply. Break it down into monthly, or even daily, fees, to get perspective as to just how much your debt truly costs. Also look for hidden costs like origination fees, early payoff penalties and more. When taking out a larger loan, consider using an interest calculator to see how much you’ll pay in interest over the lifetime of the loan. Also, Try to improve your credit score before applying to borrow any type of product so that you can qualify for the best rate and save.

Assess your personal comfort level

Putting aside the financials, you also want to take time to consider your personal feelings about money, borrowing and debt. Some people know that they are naturally savers, meaning they may be less inclined to take on debt, where others will not sweat it if they have some outstanding debt to pay back. Make sure you are comfortable with your debt tolerance and know what you are doing before taking out more and more debt.

Related: 4 Commonly Made Financial Mistakes Young Families Make