Debt: How Much Is Too Much?

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Lewis Schiff

Question of the week:
We're considering remodeling part of our house, but it will mean taking on a sizable home equity loan, which we're not entirely comfortable with. Is there a good way to know when you're taking on too much debt? -- L.K., Chicago

Dear L.K.,

You're wise to be wary of taking on new debt. Too often I see people simply borrow as much as lenders will possibly let them without ever stopping to consider if that amount of debt is actually right for them.

Your question has many sides to it, and there's no single right answer for everyone. For some perspective, we recently asked members of the Armchair Millionaire community about how much debt they're willing to take on. This comment from Mattchiavo shows how he comes up with his own answers:

Balance is everything. "I think one needs a balance. Most people will not be able to buy a home without borrowing, so you should borrow but stay at a reasonable level. Personally I like to keep my mortgage payments between 10 and 12 percent of my gross monthly pay. Do I have the biggest and nicest house? Nope, but I have a comfortable house with a comfortable mortgage. I also like to keep my car payments to 3 to 5 percent of my gross pay. Do I have the biggest and nicest car? Nope, but I have a comfortable car with comfortable payments."

Mattchiavo is on the right track. I generally recommend that people try to spend a maximum of 20 percent of their gross pay on large-scale debts related to their home in order to remain well within a common sense financial plan. However, you still need to consider the whole picture because the kinds of expenses each of us has varies so much from person to person.

When considering taking on substantial new debt, there are a few different figures that you should review to see if your personal financial profile still falls within your personal comfort zone. These are the same figures that lenders (banks, credit cards, etc.) will consider when they make a lending decision.

The Armchair Millionaire Guide to Creating Your Debt-Worthiness Profile

Ability to repay. Do you earn enough to make the payments? Do you have so much other debt that it would affect your ability to repay the new debt? Lenders often calculate your debt-to-income ratio to guide them here. This is the total amount of your monthly debt payments, including the new expected debt payment, divided by your gross monthly income.
Collateral. Is the value of your collateral (usually a home or car) enough to ensure that the lender will recoup its losses, should you fail to pay? To help them here, lenders will often use the loan-to-value ratio--the amount borrowed divided by the value of the collateral.
Credit history. When preparing to take on new debt, you should also review your credit history with the three large credit reporting agencies (TransUnion, Equifax and Experian) and close any old accounts or correct mistakes. If you've had any bankruptcies or foreclosures, this will be a significant strike against you.
Cash on hand. How much cash will you have left over after any down payment and/or loan closing costs? Do you have just enough? Or more than enough?
Purpose. Lenders also look at how you'll use the money. They might consider a loan to buy an apartment building (where you will depend on rents from tenants to be able to make your payments) riskier than a home mortgage loan, for example.

THE BOTTOM LINE: Lenders follow basic rules of thumb. You should have your own rules of thumb that balance your financial profile with your personal level of comfort. Strike a good balance between the two and you'll generally choose the smartest path.

From "Ask the Armchair Millionaire" featured each week on CNNMoney

For more Lewis Schiff articles and resources, click here.

Lewis Schiff is the author of The Armchair Millionaire (Simon and Schuster) and the creator of ArmchairMillionaire.com, the leading personal finance solutions company and web community. Each week, his column, "Ask the Armchair Millionaire" is published on CNN.com and Money magazine. To find out how you can eliminate debt, build a $1 million portfolio and boost your income, go to: ArmchairMillionaire.com.