If you feel that you have too much debt, you are not alone. Most people have substantial debt; many have more than they can handle. However, debt is not all bad. Sometimes it makes sense to use borrowed money for investments. However, most folks are not using debt in that way; they are using it to make ordinary purchases of things they would probably be better off without, anyway. In our competitive society, spending has become a status symbol. This encourages people to spend more than they should—more than they have. Consequently, they run up tremendous debt.
While some debt is okay, too much debt is not. So, how do you know whether you have too much debt or not? First let's look at the different kinds of debt we might incur.
First, there is investment debt, such as the debt incurred to buy a home (mortgage) or to start a business (equity). Generally this kind of debt is used to purchase assets that, when liquidated, will provide cash to repay the debt, or will provide income or have use value over the life of the loan that offsets the debt repayments. For example, if you borrow money to buy a house, you will have the use of the house that offsets any rent payments you might have had to pay for other shelter.
Consumer debt is the borrowing of money to buy things that decrease in value with use or over time. If you borrow money to buy a car, clothing, holiday gifts, etc., you are using consumer debt. Consumer goods become worthless over time or with use. They are consumed. But the debt remains.
Interestingly enough, it is not the amount of debt that is a problem for most folks. It is the monthly payments. There are three factors that determine how much each monthly payment will be. First, there is the amount of principal to be repaid. Second, there is the rate of interest on the unpaid principal—the annual percentage rate (APR). Finally, there is the number of monthly payments. Obviously, the more you borrow, the larger your monthly payment will be over a fixed number of months at a fixed rate. If the number of months is increased, the monthly payments will be reduced. Likewise, a lower rate will lower the monthly payments.
When a lender tells you what your minimum monthly payment is, you may be unaware that it barely pays the monthly interest and allocates only a small amount against principal. Revolving credit rates may vary, so it is that much harder to track your loan. Using the lender's minimum monthly payment could result in taking years to repay even a small debt. The result is that you pay much more for the loan than if you took a conventional loan with a fixed rate and fixed number of payments.
In order to determine whether you have too much debt, you need to calculate what percentage of your monthly take-home pay goes toward paying consumer debt. Add up all of your monthly debt payments excluding your mortgage and divide that by the amount of your take-home pay. If the amount is 15% or more, you probably have too much debt and need to take measures to reduce your monthly debt payments.
This article provided by The Educated Investor and powered by CalcXML.
© 2000-2014 Precision Information LLC. All rights reserved.