I’ve read several articles recently about how much debt is too much, or whether you should have any debt at all. While we all might strive to live a debt free life, the truth is that we are likely going to rely on debt at some time in our lives. If you want to purchase a home you will probably need a mortgage. You might just be starting out and need a car for work so have to rely on qualifying for an auto loan.
All debt does not have to be bad. The important thing to consider is what your personal debt threshold should be.
Here are three things to think about when deciding whether or not you should take on any new debt:
- Can I afford the debt I’m taking on (or already have)?
- Will today’s debt provide me with benefit even after I’ve paid it off?
- How at risk are you?
Is Your Debt Affordable?
There are a lot of rules of thumb that lenders and financial advisors use to assess how much debt you can afford to take on. For example they might say your debt repayments should be less than 36% of your take-home (after tax) income. This is called your debt-to-income ratio. To calculate yours try our debt ratio calculator. Another guideline is that you should not spend any more than 35% of your net income on housing costs (including your mortgage) or 20% of your budget (including your car payment) on transportation.
These are great but they may not work for everyone. The bottom line is you should consider the following debt management questions before taking on debt:
- Will you be able to afford the monthly payment, in full, each and every month during the entire term of the loan?
- Can you make these payments comfortably?
- Will you repay that debt within a reasonable time period? A mortgage amortization of 25 years might be good, but a credit card debt that takes 5 years to repay is not.
- Is the interest rate I am paying the best I can obtain?
This means that if you need that car loan, and can afford it, it might be a good choice for you. Same goes for an RRSP or savings loan. If you have debts that don’t meet this criteria ask what you can do to get yourself on track. If for example you think your interest rates are too high, consider a debt consolidation loan to lower your overall interest and monthly payments.
Will You Benefit?
Going on a shopping spree and using a credit card you know you can’t pay off is obviously not a good idea. While you might have that new outfit or new tablet or computer, your enjoyment of that purchase will probably be short lived while your debt repayments will remain for a long time. There is no lasting benefit to credit card debt. Period.
But what if you purchase a car with a loan or through a lease. After all you need to drive the car to work and to take the kids to activities right? True enough, but how long will that car continue to provide you with use after you complete your lease or debt payments. If you take 8 years to pay of that new car it will not be worth much by the time you finish paying for it. It may make more sense to buy a smaller car or used car, even considering repair costs, than to pay interest on a long term loan for an asset that will deflate in value.
What’s Your Risk?
The vast majority of insolvencies in Canada are caused because of an unexpected life event. Job loss, illness, injury or unexpected financial obligations can happen at any time, to anyone. How at risk are you to defaulting on your debt payments if something like this were to happen to you, even for a short period of time. Don’t take on any more debt than you can comfortably afford to repay even if your income was interrupted temporarily.
Take On No More Than You Are Comfortable With
No matter what your banker or mortgage broker tells you about how much debt you can carry, make sure you answer both questions before you sign on the dotted line. Can you afford it (now and in the future) and will it last? You may find your personal debt threshold just went down once you answer the second question.