Debt Load and Your Finances

Borrowing money is a normal part of modern finance. There's nothing wrong with it unless it gets out of hand. 

The question is, how much borrowing is too much? It depends on a few things. The amount of debt you have is important, but so are your total monthly payments, income, and wealth.

Keeping your debt load manageable is a key to healthy household finances.

What is a debt load-understanding your debt load

Debt load is the total amount of money you owe ‌others, like loans and credit card balances. It's the overall burden of debt that you carry. 

Your debt load measures the burden the amount you owe puts on your financial resources. It considers the total amount of money you owe and the total amount you need to pay each month.

Any one debt might be easy enough to manage, but if you have multiple debts, the total amount may be hard to afford. So, your debt load has to take into account the total burden created by all your debts.

Debt load also has to consider the schedule of payments on those debts. Paying down debt over a shorter period will reduce what you owe faster, but it will also require you to make larger monthly payments. 

Also, some debt payments have to be a set amount every month, while others give you some flexibility in how much you pay. 

Finally, the amount of debt load you can handle depends on your resources. How much income you have coming in is very important, but so is the value of any savings or other assets you have.

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The impact of debt on your finances

Overall, the debt load you take on might restrict your financial flexibility. It ties up a certain part of your income and can commit you to payments for years to come. Your debt load affects your finances in a few ways. 

• Spending: The monthly payments you've committed to will reduce the amount of money you have available to spend from month to month.

• Borrowing: The amount of debt you already have will limit the amount you're able to borrow in the future.

• Savings: Your monthly debt payments limit the amount of money you can save or invest in your retirement account.

• Wealth: The total amount of debt you have subtracts from your total net worth.

• Credit score: A high debt load might lower your credit score. This can make it harder to get credit in the future. It also means you are likely to pay higher interest rates when you borrow.

Understanding debt load helps you measure how much it is restricting your finances. Ideally, it will also help you anticipate those restrictions before you borrow so that you can make good financial decisions. 

Assessing your debt load

According to the Federal Reserve Bank of New York, the average American (for May 2023) with a credit report owes slightly over $60,000. 

On the surface, that might seem like a useful measuring stick for assessing your debt load. At least you can check whether you have more or less than the average amount of debt. However, that average doesn't really tell you much unless you have a little more context. That's why it's important to look at debt relative to net worth and income. 

Debt and net worth

Your net worth is the value of all your assets minus the amount of debt you have. 

This is important because some debt simply subtracts from your net worth, while other debt allows you to acquire an asset to offset the debt.

For example, if you get a mortgage to buy a house, the value of that house offsets the mortgage. On the other hand, if you use your credit card to pay for a vacation, there is no asset to offset the credit card balance you now owe.

This creates some context for the amount of debt you owe. $60,000 in debt is not such a big deal if it is offset by an asset. However, if you received no asset of lasting value in return for that $60,000 in debt, it simply subtracts from your net worth.

Debt-to-income ratio

Looking at debt in the context of your net worth is a useful measure of your long-term financial health, but it tells you nothing about the immediate problem of coming up with the monthly payments on that debt. 

For this, you need to look at your debt-to-income ratio. This is the total of your monthly debt payments as a percentage of your household income.

Here's a simple example

• Maria has a $1,500 mortgage payment and a $400 car payment to make every month

• Maria earns $6,000 a month

• Maria's total debt payments of $1,900 represent 31.7% of her income

• So, Maria's debt-to-income ratio is 31.7%

That's a start, but people don't generally have all of their income available to put toward debt payments every month. For one thing, taxes take a bite out of each paycheck. Then there are essential expenses like food and utilities.

This is why it's useful to look at debt-to-income ratios using discretionary income. Discretionary income is the amount of money you earn after taxes and other necessary expenses are taken out.

According to the Federal Reserve, for U.S. consumers debt payments as a percentage of discretionary income have averaged from 8.31% to 13.17% over time. For some households, debt-to-income ratios are often higher than that range. There isn't necessarily anything wrong with that. It depends on the type of debt and whether you are just starting your career or approaching retirement. 

Analyzing your monthly payments

Another key thing to consider about your monthly debt payments is whether they are fixed or variable. 

In part, this depends on the type of loan you have. If you have a fixed-rate mortgage, you can count on those payments remaining the same over the life of the loan. If you have an adjustable-rate mortgage, you should be aware that those payments could increase if interest rates rise. 

Also, unlike most loans, credit cards have no set repayment period. They require only a relatively small minimum payment every month, though you can pay more if you choose to.

Those low minimum payments can be a bit of a trap. Credit card companies set them low to stretch out repayment over a longer period so you pay more interest. So, it's wise to plan on paying more than the minimum required on your credit card bills. Still, it's nice to know you have the flexibility to pay less in some months than in others when you need to. 

Strategies for managing your debt load

Here are some ways to keep your debt load manageable:

1. Budgeting. Plan the amount and ‌timing of your income and ‌payments. Project these amounts into the future. This will show you what you'll be able to afford. Recognize which expenses could be cut and which cannot.

2. Prioritizing payments. Some debt is more expensive than others. For example, in mid-2023 credit card rates are up over 20%, while mortgage rates are about 7%. Make the minimum required payments on each debt you owe, but if you have any money left over, use it to pay down the highest-interest debt first. 

3. Debt consolidation. This involves taking out a new loan to pay off some of your existing debts. Depending on what your goals are, it can be used to simplify your monthly payments, lower those payments, or reduce the total interest you'll pay over time.

4. Credit counseling and other professional advice. If you need help handling your debt, there are plenty of options. Credit counselors can advise you on budgeting and making your payments more manageable. A debt relief program can help you negotiate to reduce the amount you owe.

Tips for avoiding future debt problems

If you're like most people, you should be able to borrow money from time to time without any trouble. Here are some tips for using debt without it getting out of control

1. Budget before you borrow. Just because you can borrow doesn't mean it's a good idea. First, you have to plan. Budget for how your income will cover any loan payments, normal expenses, and other future needs. Budgeting allows you to anticipate potential money problems before taking on new debt.

2. Building an emergency fund. Budgeting is about planning, but some expenses are unexpected. It helps to set aside some money to handle those emergencies. That way you won't have to borrow when an unexpected expense comes along.

3. Practicing responsible credit card usage. Credit cards are a great convenience, but sometimes paying the bills isn't so easy. Plan for how you are going to use your credit cards so you can avoid impulse buying.

4. Developing good financial habits. Budgeting, avoiding overspending, and paying your debts down are all good financial habits. Like any habit, they may take some work to develop, but they become easier once you are used to them. 

The benefits of reducing your debt load

There are several benefits to reducing your debt load:

• It ties up less of your money, so more will be available to you in the future.

• It reduces the amount you pay in interest, so more of your money can go toward things that benefit you.

• It can raise your credit score, making future borrowing more available and less expensive.

Perhaps the biggest benefit of reducing your debt load is peace of mind. Not having to fret over where your next payment is going to come from will help your financial and mental health.