So much debt is too much debt, exactly? Is it $5,000? What about $50,000? The truth is there’s no clear-cut answer to this question. Every person’s capacity to handle debt differs based on various factors. These include their income, age, credit score, and family obligations. The type of debt owed and its interest rate also matter, too.
However, some rules of thumb and warning signs can help you assess whether or not your debt obligations are sustainable. In this guide, we’ll show you how to tell when you’ve overextended yourself. By doing so, you can take steps to reign in your debts and avoid financial distress.
Debt-to-income ratio
Let’s start with one of the most popular metrics for measuring debt obligations: debt-to-income ratio (DTI).
The DTI ratio tells you how much of your monthly income goes toward paying off debt. It’s typically expressed as a percentage and encompasses all your monthly debt commitments. These include mortgages, credit cards, installment loans, auto loans, and bank overdrafts.
The DTI also includes various other recurring liabilities you have an agreement to pay: utility bills, medical debt, insurance, alimony, child support, rent-to-own furniture, etc. Non-essential expenses, such as streaming subscriptions, are excluded.
To calculate your DTI ratio, divide your total pre-tax monthly income by your combined debt payments and multiply the resulting figure by 100. For example, if your pre-tax income is $7,000 and your debts total $2,850, your DTI ratio is 40.71 (or about 41%).
Why your debt-income-ratio matters
Generally speaking, the lower your DTI, the better your financial health. A low DTI ensures you can easily cover your debt payments, given your take-home pay. As a result, you’ll be far less likely to encounter debt problems, such as paying late or having accounts sent to collections. Your credit score will also remain high, all other things being equal.
A low DTI ratio also increases your chances of qualifying for new loans and securing low interest rates and favourable terms. The reason is that lenders use the DTI ratio when deciding whether to lend you money or increase your credit limit. If your debt load is modest, they’re more willing to approve your application since you’re unlikely to default.
However, carrying too much debt relative to your income makes you appear more risky to lenders. As a result, your loan application will likely face rejection, even if your credit score is in decent shape. Alternatively, you may get approved at a higher interest rate that reflects your risk profile—but you could end up paying a costly loan that can lead to future debt issues.
What’s the ideal DTI ratio?
Generally, a good debt-to-income ratio is between 36% and 43%. Many financial experts consider any ratio above 43% to be excessive.
Traditional lenders in Canada will be hesitant to lend your money if your DTI exceeds 43% (with the new loan payments included). If your DTI exceeds 43%, you may have to seek out subprime lenders to secure financing, especially if your credit is poor. With a high DTI, you’re at a higher risk of insolvency. Lenders like the Big Five banks won’t want to assume that risk by accommodating you as a borrower.
Credit utilization ratio
The credit utilization ratio (also known as the debt-to-credit ratio)is another formula you can use to check whether you’ve taken on too much debt. It’s also one of the primary factors credit bureaus use to calculate your credit score.
A credit utilization ratio measures how much of your total credit you use versus the amount you have available. It applies to revolving credit products like credit cards and lines of credit: accounts where you can borrow at your discretion up to a pre-determined limit.
For example, assume you have two credit cards, each with a $5,000 credit limit. The current balance is $1,000 on one card and $2,200 on the other. Therefore, your credit utilization ratio for the two cards is 32 or 32% ($3,200 / $10,000).
Why your credit utilization ratio matters
The higher your credit utilization, the more likely you are to face debt problems down the road. The reason is that revolving credit products tend to charge higher rates since they’re primarily unsecured debts. As your balance grows, your interest charges skyrocket. Eventually, the debt becomes too massive to repay.
Lenders review your credit utilization to assess whether you’ll have trouble repaying your current debts with your new loan. High credit utilization may indicate a heavy reliance on borrowing, elevating the risk of default. As a result, you’re less likely to qualify for financing.
Credit utilization also impacts your credit score; another factor lenders evaluate when deciding whether to lend you money. Your credit score drops as your credit utilization increases, and vice versa.
What’s the ideal DTI ratio?
Generally, a credit utilization ratio between 30% and 35% is acceptable. You shouldn’t face many issues staying current with payments in this range. Your interest should be manageable, too.
However, some lenders prefer a 30% or lower ratio. In addition, you’ll want to consider your interest rate. For example, assume your credit card charges 24% on regular purchases, and you carry a balance. A 30% ratio could lead to lots of interest collecting on your account.
Are specific debts causing you problems?
The guidelines below will give you an idea of how much debt you can afford based on loan type.[MG1]
Mortgage (and other housing costs)
The general rule of thumb is to limit your mortgage, interest, property taxes, heating costs, and insurance to 30% to 32% of your gross monthly income. These five expenses are the primary factors that lenders use when evaluating your mortgage application. Mortgage lenders also expect a DTI ratio no higher than 43%. However, some may impose stricter standards for borrowers.
Similar standards apply to mortgage insurance. For example, the Canada Mortgage Housing Corporation won’t insure your mortgage if:
- Your total debt load exceeds 44% of your gross household income and
- Your housing costs (including the mortgage) exceed 39% of your gross household income.
A mortgage calculator can help you estimate your ideal mortgage size.
Car loan
Your total principal and interest costs for a car loan should be no higher than 15% of your net income. Therefore, if you earn $60,000 annually after taxes, your maximum payment is $750 per month (($6000 x 0.15) / 12). Some financial experts advocate a more conservative figure of 10%, especially since you need to factor in the insurance cost.
Another popular guideline to keep your car loan manageable is the 20/4/10 rule. This rule suggests making a 20% down payment, asking for a four-year term, and keeping your monthly car loan payments at 10% or less of your pre-tax income.
Check out this car loan calculator from CIBC to learn how expensive a vehicle you can afford.
Credit card
Aim to keep your credit card payments at or below 10% of your net income to avoid a dangerous debt spiral. Keep your credit utilization low, preferably at or below 30%. High credit utilization can harm your credit score.
Try out a credit card repayment calculator to get an idea of the cost of excessive credit card debt. You might be surprised (or shocked) at how much money you’re spending on these plastic cards. Implementing a repayment strategy like the debt snowball or debt avalanche can help reduce your balance to a manageable level.
Student loan
The danger zone for student loans is trickier to estimate. However, you can follow some rules of thumb to avoid financial trouble and pay off your student loans faster.
The first rule is don’t borrow more than your expected starting salary out of college. For example, if a typical entry-level salary in your field is $50,000, avoid borrowing more than $50,000 to finance your education. The second rule is that your loan payments should not exceed 10% of your gross income.
Common warning signs of too much debt
Signs of debt distress can be readily apparent in day-to-day life. You may have more debt than you can handle if:
- You consistently carry a large balance on your revolving credit accounts
- You can’t afford to save money for long-term goals like retirement
- You can only afford to make minimum payments on your credit cards
- You frequently apply for new credit
- You use one loan to pay another rather than paying off the balance in full
- Your outstanding balances keep increasing despite making regular payments
- You routinely have to decide between making a loan payment and paying crucial household bills
- You rely on high-interest debts like cash advances and payday loans.
- You borrow continuously to pay for everyday expenses like groceries
The bottom line on how much debt you can afford
The optimal level of debt varies from person to person. A 22-year-old who recently finished university won’t have the same debt commitment level as someone about to enter retirement. However, the DTI ratio, credit utilization ratio, and similar financial metrics can help determine if you’re taking on more than you can afford.
Still, the most important thing you can do is recognize the warning signs of excessive debt. If you’re struggling financially, the best thing you can do is be honest about your predicament and take steps to address the problem. And there’s no shame in asking for help if you can’t fight the battle alone.
At David Sklar & Associates, we’ve been helping people across Ontario eliminate their debt problems since 1997. Our experienced and compassionate team of Licensed Insolvency Trustees specialize in all forms of debt relief, including personal bankruptcy and consumer proposals. Book a free no-obligation consultation today to learn about your options. No matter how dire your situation is, we can help you find a way to tackle your debts and start fresh.
