Debt has been responsible for adding extra stress onto many people's lives. Having a healthy credit rating is a sign of financial stability and responsibility. But, how much debt can you incur before it becomes unhealthy?
Understanding Debt Service Ratio
One place to find out about a healthy debt limit is from your bank or other financial institution. Banks and other lenders make a decision on the amount of debt you can handle based on what percentage of your income your debt repayments are taking up. And 40% is the golden number to remember.
If you add up all your expenses – including debt repayments, mortgage installments, heating bills, taxes etc. – the total monthly amount shouldn’t be more than 40% of your monthly income. This is known as Total Debt Servicing Ratio, which is also known by the acronym TDSR. If you try and apply for more credit when your expenditures are already around the 40% mark, you’re likely to receive a rejection from almost every lender.
You may ask why 40%? Why don't the financial institutions use 30% or 50%? It's really all based on statistics, and if you drill down into the details, it can get extremely complicated. The basic point to grasp is that banks have seen a healthy return when loaning money to individuals who have no more than 40% of their income going towards debt expenses. This is because the default rate, even for those with debt levels approaching the upper limit, are within a range acceptable to the lender.
But is this level of risk acceptable to you? While this may be a good rule of thumb for your lender, the level of debt you should consider healthy will depend on your unique circumstances. Regardless of your debt servicing ratio, you need to know that you can comfortably afford your monthly payments (both principal and interest) now and in the future and that you will be able to repay your debt within a reasonable period of time.
You may find a lender who will be willing to lend you a certain amount of money even if your liabilities exceed 40%. This is how most people get into a whole lot of trouble though, especially if you are borrowing money at a high interest rate. Any form of credit card debt that you are paying off over time is not healthy debt.
If you are not sure how much risk to assume, read Howard Hayes' article on this same subject where he talks about how sometimes a debt service ratio of 20% to 30% can be too much. He looks at how to reverse the calculation by looking at what you need to live on first. He also talks about the key warning signs of too much debt.
Mortgages and Gross Debt Service Ratio
Mortgages also take into account something called Gross Debt Servicing Ratio, also known as GDSR. This represents your housing costs, that is to say, the amount of money that you spend on shelter; so things like mortgage payments, heat, taxes, and condo fees. If the cost of your GDSR exceeds 32%, most banks will reject your application for a mortgage.
Again, you may be able to find a lender who is willing to give you a mortgage even if your GDSR is above 32%, but just like with any other lender, make sure you know what you're getting yourself into, and that you’ve calculated your monthly costs. Some lenders will charge you much higher interest rates if your servicing is high to minimize their risk if you default on your payments.
It’s important to be smart about your borrowing and avoid practices that might leave you dealing with an unmanageable amount of debt that you are unable to repay. Keeping your debt repayment load under the 40% mark is one way of avoiding having too much debt but better still make sure your debt repayments fit within our personal budget. If they don’t, you may have more debt than you should.
Are you concerned that you have too much debt to deal with on your own?