How Much Debt Is Too Much Debt?
Guess what my first answer to this question is. Go ahead. Guess. Right… any consumer debt - that’s stuff on your credit card or line of credit that went towards anything you didn’t need - is too much debt. Pretty hard-line, eh? Yup.
That being said, I do allow for the fact that people have some debt. On the “Life Pie” you can spend up to 15% for debt repayment (not including your car payments and your mortgage). To calculate what percentage of your income you’re spending on debt repayment, add up your monthly debt repayment amounts (not including your car payments and your mortgage), divide that by your monthly take home pay, and multiply it by 100.
If you’re spending $670 a month paying off your credit cards, student loans, line of credit, furniture loan, or whatever else, and you make $3100 net a month, your calculation would look like this:
670 / 3100 x 100 = 21.6%
If you’re spending 15% or less of your monthly income paying off your debt then you’re okay. Not great, but not drowning. If you’re spending more than that, uh-oh!
The words “paying off” are important. If you’re spending 15% or more of your income just meeting your minimum monthly payments, then you’re in trouble and headed for a fall. Making just the minimum payments on credit cards means you’re gonna be in debt FOREVER and you’re going to pay GOBS of interest.
If you have a $3,000 balance on a credit card charging 14.98% interest, and pay a 2% minimum every month it will take 26 years to pay off your balance and cost you a total of $7,440 in interest. Yuck!
There are some other signs that you may be in over your head. If you find, for example, that you seem to have less and less money for things like food because you’re spending more and more money trying to keep up with your debt, that’s a bad sign. And if you keep dipping into your savings, keep trying to refinance, or have to take a payday advance loan, it’s a sign that you’re over-extended.
Another big clue: you keep hitting the ceiling on your credit cards. If as soon as you pay down balance, do a balance transfer to reduce your costs, or refinance in some other way, you’re right back to the limit on your credit, you’re in deep doo-doo.
Ditto if you can’t find two red cents to put into an emergency fund. No emergency fund means that the first time Old Man Trouble rears his ugly head, you’ll be right back using your credit to fill your financial gap. That’s no way to live.
And, finally, if you can’t sleep at night, if you toss and turn or awake in a cold sweat, you’re in trouble. Why are you doing this to yourself? Taking care of the problem is so much easier.
First, admit you have a problem. Say it out loud right now: “I have a problem with my debt.” If you aren’t prepared to admit you’re in trouble, no one can help you. If you aren’t prepared to add up the mess you’re in, you’re not ready for help yet. Quit your whining. If you want things to change, start by saying, “I have a problem with my debt.”
Second, start writing down every penny you spend. Whether you spend $1.25 for coffee or $600 on a fabulous new pair of shoes, write it down. This is how you become accountable for forfeiting your future in the name of an immediate pleasure. When you look over your list at night - yes, you have to look over the list every night - ask yourself why you’re really buying. Did you get a rush? Did you feel pleasure? How are you feeling now?
Third, switch from credit to cash. It’s way easier to charge something than it is to fork over cold, hard cash, particularly when you’re getting to the bottom of the jar.
Step four: commit to paying off your debt. Allocate a fixed amount to each debt, paying off the most expensive debt first while you make smaller payments on the other debts. Once your first debt is paid off, reallocate that money to your next most expensive debt. Keep going till you’re out of the hole.
Don’t have the money to make a dent in your debt? GET A JOB! Another job, a better job, I don’t care. MAKE MORE MONEY! Hey, you’re the one who went out spending money willy-nilly, without a thought to how you were ever going to pay your creditors back. The time has come to pay up. So suck it up, find a way to get out of debt and get your life back!
Staying out of consumer debt isn’t an impossible feat. It’s a matter of not spending more money than you make. That’s right. It means not buying something when you don’t already have the money to pay for it. Life is expensive enough. Why would you add interest to the equation?
April 24th, 2008 at 9:53 am
Great post!
I have asked this before and maybe someone can help me. I have two student lines of credit and one Provincial Student loan with interest rates at 6.75, 7.5 and 8.75 respectively. I want to know which one to pay down first. The amounts on each loan are 2,600, 9,980 and 6,500. I know I should be paying down the highest one first BUT it’s a provincial loan where as the others are stupid consumer debt. Because the interest is close and the amount on one of the lines higher should I not be paying that first?
I wish there were more shows on people in my position!
Keep up the great work.
April 24th, 2008 at 10:30 am
Gail, you said it all when you wrote
“Life is expensive enough. Why would you add interest to the equation?”
Great explanation on how to get and stay on top of our finances!
April 24th, 2008 at 11:08 am
Melissa,
Technically speaking you should pay off the one that carries the highest interest rate first. But…. given the rates are all somewhat close, I would advocate paying off the one with the lowest balance first. The idea is to obviously keep making the minimum payments on all of your debt, but put whatever you can towards that smallest one to get it gone asap. That will give you the boost you need and pat on the back that you are making your debt go away. It is a wonderful feeling to start knocking off those loans/credit lines and the fastest way is by tackling the smallest one first.
April 24th, 2008 at 11:49 am
Government based student loans have an interest rate which is tax deductible at the base level. So you might want to ‘correct’ for that.
8.75% * (1-Fed-Prov) = interest money payed in %
where Fed is the basic federal tax rate from schedule 1, line 24 or 338 (usually 0.15) and Prov is the basic provincial rate (depends on your province, but it is from the non-refundable tax-credit worksheet) so it could be 0.10 to 0.20 (15% = 0.15). And I do not know the details in QC.
So at least, this is how I understand it so someone correct me if I am wrong! Really, do!
This assumes that you do something useful with the tax return you get (like pay down more debt or setup an RRSP). REALLY!
Other very important aspects to consider for every loan agreement:
1- Are you allowed to pay more than the basic amount without penalty?
2- If you increase the amount, can you reduce it if problems arise?
3- Which will influence your credit score and how?
4- Do you have room for that tax credit?
5- (I am not sure is the interest rate is locked in for every loan from your statement.)
6- Do you have an emergency fund with at least 3 months of expenses?
7- Is your total monthly payment below 15% of your take home pay?
8- What budget is in line with your values and wishes (see Christina’s point above)?
[disclaimer: not a tax specialist, see a professional for better advice, use info at ownrisks]
In the end, it does not matter if it is consumer debt or student loan (chances are that you consumed while being a student). The one which is costing you more deserves attention.
Based on Christina’s post:
If you pay off the smallest debt fast, your 3-months emergency fund is lessened once that debt is payed off. Again, your values and personal tricks are important. Some prefer to reduce the number of loans, some prefer to reduce the total amount due ASAP.
In short: 15%!
April 24th, 2008 at 4:12 pm
All of the points raised by Marie are legitimate, but I am still an advocate of paying off the smallest loan first especially because in Melissa’s case, the interest rates are not all the different.
The mental gymnastics to figure out which one actually costs you dollar for dollar more and should therefore be paid off first are just not worth it compared to the weight lifted off your shoulders when one of your creditors is gone (no price tag on that feeling). This is especially true if you plan on paying them off fairly soon so you are really only talking about the difference in interest rates over months, not decades.
Seeing your creditors get knocked off builds your momentum and enthusiasm for continuing with paying off your debts. When you’ve paid off the smallest one, then put that now freed up money onto the next smallest debt, you build momentum at a very rewarding pace.
April 24th, 2008 at 5:28 pm
I definitely agree with Melissa about paying off the smallest ones first if they are similar. I have done this and it does feel SOOO great to get a couple monkeys off your back, so to speak.
April 24th, 2008 at 7:22 pm
“Life is expensive enough. Why would you add interest to the equation?”
Gail, you don’t only show that you have great with money, you are great with words, too!
My situation is similar to Melissa’s. I have 2 student loans. The bigger one has a higher interest rate while the smaller loan has a lower interest rate. I choose to pay off my bigger loan first because of the interest rate.
Melissa, I think you should make the choice as to which loan you want to pay off first. I know the logic of paying off the smaller loan first (Christina explains it quite clearly here). But I have been paying them for a few years, so the commitment is there. In fact, I could see that I would be debt free probably by next year. That’s enough encouragement for me.
April 24th, 2008 at 7:51 pm
Okay, here’s the skinny on what to pay off first:
• the most expensive debt, particularly where there is a big spread in interest rates (regardless of how big your balance is)
• among multiple lower rate loans, pay off the smallest balances first so you can snowball the payments on the next loan
• when figuring out which rate is highest, you do have to correct (as Marie said) for any interest tax credits on student loans
• as for the “will you be able to up your payments” question, virtually all consumer credit is repayable early (even installment loans) without penalty. Mortgages are not.
April 26th, 2008 at 5:33 am
Also, don’t forget that the Government loans offer interest relief and other assistance programs if your income drops below a certain level (admittedly, a low one!). I’d pay off the commercial ones first: the tax-deduction and the moderate flexiblity of the government loans makes them a better long-term debt.
And the government loans do allow you to make extra payments without penalty: this really helps reduce them fast. I had two loans — one provincial & one federal — and being able to throw money at them whenever possible means that one’s gone and the other is down by half.
April 28th, 2008 at 9:43 am
Can someone help….how do you calculate how long a loan will cost….interest rate and all….I cannot figure it out myself and just want to be able to know how??? Thanks
April 28th, 2008 at 10:07 am
To Pamela - check out http://www.bankrate.ca They have a loan amortization calculator. It shows you how long it will take you and how much interest it will cost you.
April 28th, 2008 at 11:19 am
To Sally,
Thanks for the information…!!
April 29th, 2008 at 7:04 pm
hey, thanks for the information.. I do want to say, that in my defence, being reassessed by rev canada for 7 years worth of earnings then slapped with a 100,000.00 payback which has pretty much put me under drowning… didn’t make me a bad spender… NOW HOW DO I GET OUT OF THIS ONE GAIL??????????
NOT ALL DEBT IS CAUSED BY THE USER!!!!!
I FIRED THE THREE ACCOUNTANTS WHO SCREWED ME OVER BY THE WAY!!!!
April 29th, 2008 at 7:11 pm
Penny:
Accountants are professionals, will they correct their mistake? Will you make them? They don’t want complaints or lose their status. Ask a professional about getting some back from them…
April 29th, 2008 at 11:02 pm
Thank you to all who posted about me situation! So helpful. What I hasn’t mentioned was that I have already managed to pay off 4,000 of Credit Card debt on a pittance of a salary and having that GONE does feel great. Nice to know I am on the right track!
Thanks again,
Melissa