It's your ability to repay your debt that matters; regardless of the size of that debt.
What Is Credit Capacity?
From a lenders perspective, they often consider you to have too much debt if your monthly payments, including lines of credit, car payments, mortgage payments and property taxes, exceeding 40% of your total household income. This credit or debt capacity is referred to as your total debt service ratio.
To calculate yours, add up all your monthly debt payments (you should include rent if you are a renter) and divide the total by your income. Multiply by 100 to get your percentage.
If the resulting calculation is over 40% a bank will likely consider you to have too much debt. With a debt service ratio of over 40% there is a high risk that you will default on your loan payments.
However our experience has been that people with as low as 30% or even 20% debt service ratio can find themselves in trouble. The reason for this if often because most people include only their minimum payments when doing the calculation or don't take into account extra living expenses they may have.
How Much Can You Afford?
Rather than looking at how much debt you can carry, it's better to look at the situation in reverse. How much money do you need to live? Add up all of your living costs, including your rent or mortgage, food, utilities, transportation and other personal costs. Add in a 'cushion' of 10% or so for incidentals you may have missed. Now take that number and divide it by your income. If you need 80% of your income to cover day to day living expenses, your monthly debt payments can't exceed 20% or you are in the hole.
The result of being in the hole each month is like the pressure building up on the side of a glacier. You will have to turn to more credit to balance your budget. This increases your debt payments, increasing the pressure. Sooner or later something crumbles.
Warning Signs For Too Much Debt
You don't have to run a bunch of numbers to figure out that you are in over your head. Here is a list of actual consequences that can happen when you carry too much debt:
- Feeling stressed and worried – if you think you have too much debt, chances are, you probably do.
- Losing sleep – you likely have too much debt if it keeps you up at night.
- You spend more than you earn each month.
- Debt payments consume a large portion of your income.
- You can’t pay your bills on time.
- You’re receiving collection calls and letters.
- You live off of your overdraft and lines of credit.
- Payment of utility bills and housing bills often get behind.
- You pay minimum payments by transferring balances from one line of credit or credit card to another.
- You don’t pay your credit card balances in full each month.
- You don’t save any money at the end of the month because it all goes to interest costs.
- You’ve been declined for debt consolidation by your bank.
- You don’t open your bills and instead allow them to pile up for fear of the amount.
- You hide your debt or spending from your family.
- You spend impulsively and recklessly because you’ve given up trying to pay the debt down.
What Should You Do If You Have Too Much Debt?
If you can relate to any of the signs listed above, it’s important to look for possible solutions. Some of these options include:
- Contacting your creditors or collection agents – see if any are willing to help by reducing your payments and/or interest rates. If you don’t ask, you’ll never know.
- Make a budget – Can you increase your income and cut back expenses. Review all of your expenses and create a household budget, if you haven’t already. Can you work overtime, get a 2nd job, or sell unused household items to generate additional income?
- Credit Counselling – If you think you can repay your debts in full, look for help from local credit counselling agencies that can work on your behalf with your creditors to set up a debt repayment plan.
- Consumer Proposal – Reduce the amount of your debt and extend the time you have to pay off that debt.
- Personal Bankruptcy – If none of the above work, bankruptcy could be a last resort option.