Carrying too much debt not only keeps you from accomplishing your goals but also lowers your credit score. This makes it harder to get loans with favorable terms and low interest rates. This article explains the difference between revolving and non-revolving debt, “good” debt and “bad” debt, and the financial consequences of having too much debt. We’ll also explain how to calculate your credit utilization and debt-to-income ratio, two factors that lenders consider in approving loans.
Written by Attorney Serena Siew.
Updated October 19, 2021
You probably already know if you have too much debt. Just admitting that you have a debt problem is half the battle. This article explains revolving and non-revolving debt, “good” debt and “bad” debt, and the financial consequences of having too much debt. We’ll also explain how to calculate your credit utilization and debt-to-income ratio, two factors that lenders consider in approving loans.
If you’re maxing out credit cards, you may want to tighten your belt to boost your credit score before taking on another loan with high interest. Finally, if there’s no way to catch up on repayment, filing for bankruptcy may be a good plan. Read on to learn the warning signs that you might have too much debt and the disadvantages of taking on more.
Determining How Much Debt You Can Afford To Repay
You have too much debt if you can’t realistically repay it. Before you take out a new loan or make new purchases on credit, it’s important to figure out how much debt you can actually afford.
Start by calculating your monthly income. Then, gather statements for all your debts (credit card balances, car loans, medical bills) and figure out your minimum monthly payment for each. Add all these together to get your total monthly debt repayment amount. Now add up your monthly expenses, including necessities like housing and groceries. Subtract your debt repayment amount and monthly expenses from your total monthly income. What’s left?
If you only have a few dollars extra each month — or worse, you’re in the red each month — you may have too much debt. Doing this exercise can help you determine whether your debt is eating into your quality of life or you're relying too much on credit. You may think that you’re managing your debt okay if you’re able to make your minimum payments each month, but these payments are often just 3% of your balance. So, if you’re only able to make minimum payments, you can fall deeper into debt as interest accrues. This can keep you in debt for many years.
Taking Out More Loans
If your strategy is to take out a loan to pay your debt, don’t rely on lenders to look out for your interests. They may lend you money that will be very hard or impossible to repay. When it comes to taking out any loan, remember:
Even if you find a loan with a low interest rate, if you borrow too much, monthly payments will still be high because you’ll have so much to repay.
Higher monthly payments mean that you’ll have less cash available in the future to spend on things you want or need.
Avoid borrowing more than you can afford to repay because under some circumstances, lenders can sue you if you don’t repay your debts.
Yes, a lender may sue you in court. If a lender gets a default judgment against you, they can take money from your paycheck or bank account. Filing for bankruptcy is one way to prevent this from happening. When you file a bankruptcy petition, you’ll benefit from an automatic stay, which halts all collection activities, including most lawsuits.
Too Much Debt Will Cost You Money
Generally, the more you borrow, the more you’ll have to pay in interest charges. Some loans are more expensive than others. Credit cards, for example, carry significantly higher annual percentage rates (APRs) than other debts. APR reflects how expensive a loan is on a yearly basis. Here are some typical interest rates for different loans:
2.863% average APR on home mortgage
2.49%–3.54% APR on student loans
3.24%–13.97% APR on auto loans
19.62% APR on credit cards
Credit cards clearly have much higher interest rates than other loans. Credit card issuers can also charge compound interest and extra fees on a daily - not annual - basis. This can make credit card debt costly. If you have too much credit card debt, you may want to consider a balance transfer onto one card with 0% APR - unless you won’t be able to fully repay the transferred debt before the introductory 0% APR rate skyrockets.
Credit Scores Influence Interest Rates
The better your credit score, the lower the interest rates you’ll get on new loans. In the case of auto loans, people with good credit qualify for 3.24% APR while those with poor credit may be charged 13.97%. If you have a good credit score but are still being charged high interest rates, you can:
Try shopping around to find better deals, including refinancing home or auto loans to bring down the interest.
Make a larger down payment to qualify for better interest rates and decrease your monthly car payments.
Take out a personal debt consolidation loan to pay down credit card or other debts.
Interest on most loans accumulates daily or monthly. This means that the longer it takes you to pay off the loan, the more expensive the loan will be overall. Think of the total cost of interest you’ll end up paying, and then decide if the loan payments are worth it.
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Too Much Debt Can Set You Back
You might hear people talk about “good” and “bad” debt. While there’s no hard-and-fast rule for what’s good and bad, generally, good debt has a lower interest rate, helps you build equity, and helps your future.
For example, a home mortgage is considered good debt because it helps you avoid paying rent while building equity. This means that you own a greater share of the home’s total value with each month of payment. Student loans may also be a good investment if they help increase your future income. But that’s only if you graduate and get a high-paying job. If you borrow too much, drop out after your first year, or can’t find employment, that’s a different story. Student loans are also not dischargeable through bankruptcy.
Bad debt includes loans with high or variable interest rates used to purchase things that lose value. Examples include:
Taking out loans for vacations
Car loans that last more than five years
Credit card debt with high balances and interest
No-credit-check and payday loans with over 36% APRs aren’t just bad debts, they’re toxic. Because of their high interest rates, you could end up owing more than the item you borrowed for is worth.
Compare a $100,000 home mortgage at a 3% interest rate versus $20,000 in credit card debt at 24% interest. The person with a lot of “good debt” at low interest may be in a better financial position than someone with a lot of “bad debt.” But that’s not always the case. Whether a loan is good or bad always depends on your specific situation. If, after budgeting, you don’t have extra cash flow to repay debt, ask yourself if too much debt is stopping you from:
Accomplishing your goals
Finding a safe place to live
Building an emergency fund
Having enough money for things you need
Under these circumstances, bankruptcy could be the right answer. If you’re struggling with credit card payments or need help managing your personal finances, you can seek nonprofit credit counseling, talk to consumer debt advisors, or ask a professional bankruptcy attorney for guidance.
Too Much Debt Can Impact Your Credit Scores
There are many types of credit scores, including FICO and Vantage. A credit score is a three-digit number between 300 and 850 based on your credit reports. Lenders use different formulas but consider similar factors in calculating your credit score. Here’s a common breakdown:
35% payment history
30% amounts owed/credit utilization rate
15% credit history length
10% new credit
10% mix of credit types
If you fall behind on paying your bills, this will have a negative impact on your payment history. If you use too much of your available credit, which means you’d have a high credit utilization rate, this will also affect your credit score. Together, your payment history and utilization make up 65% of your credit score, so focus on paying on time and not using too much of your credit limit if you want to boost your credit score.
Credit Utilization Ratio
FICO considers your credit utilization in weighing your score. The total credit you have available is known as revolving credit. Your credit utilization ratio is the percent of revolving credit that you’re using at any given time. To find your utilization ratio, divide the balances of all your credit cards by all their credit lines or limits. Take the following example:
$5,000 balance with $10,000 limit
$2,500 balance with $8,000 limit
$2,500 balance with $7,000 limit
Your total monthly credit card debt is $10,000 and your total credit card limit is $25,000. Your debt divided by your limit is 40%. This is your credit utilization ratio. Financial advisors recommend keeping your rate below 30%. Here, less is more. The lower your utilization, the higher your FICO credit score.
Although the relationship between your total amount of debt and credit score isn’t a simple 1-to-1 relationship, generally speaking, maxing out your credit cards increases your credit utilization ratio and lowers your credit score. And while paying off credit card debt is not guaranteed to raise your credit score, it’s still worth doing because it can save you a lot of money on interest.
Calculating Your Debt-to-Income Ratio
Calculating your debt-to-income (DTI) ratio is one way to figure out whether your debt is too high and how much debt you can actually afford. Some lenders will consider your debt-to-income ratio and may limit the maximum DTI they’ll accept for new borrowers. To calculate your DTI, first list any recurring debts that you must pay every month.
Next, distinguish net income or net worth from gross income. Net income is what you make each month after subtracting taxes, also known as your take-home pay. Gross income is what you make each month before taking out taxes, insurance, and Social Security. DTI focuses on gross income.
Finally, add up your total monthly debt payments and divide by your gross monthly income. For example, if your recurring monthly payments include:
$1,000 for a home mortgage
$1,000 for credit cards
$500 for an auto loan
$500 for student loans
Your recurring debt is $3,000 per month. Now if your gross monthly income is $6000, your DTI would be $3,000 divided by $6,000 or 50%. Financial advisors recommend a DTI under 35%. But lenders will take DTIs of 50% because they want to make that loan.
To summarize, having a DTI that is:
Lower than 35% can lead to better interest rates and easier loan approval
Higher than 35% may mean you’re carrying too much debt
Higher than 43% will make it more difficult to secure a mortgage
Between 36%-49% may be acceptable to lenders who want to close a deal
Between 40% and 50% is considered relatively high
Generally, if your DTI is low, lenders may be more lenient with the terms of a loan. If your DTI is high, lenders might be more strict and require you to have a good credit score and a very stable job before they’ll approve a loan. Yet, for a conventional home mortgage backed by Fannie Mae, borrowers can have a DTI of up to 50%. This means that you may still be able to get a mortgage with a “high” DTI.
Just remember that lenders normally consider what your DTI would be after they give you a loan. A home mortgage automatically means a higher DTI than rent because a monthly mortgage payment is part of the DTI calculation but rent is not.
What To Do if You Have Too Much Debt
If you have more debt than you can afford, filing for bankruptcy may be a good option. This is especially true if you have a lot of unsecured debt like credit card bills or medical debt. In fact, Chapter 7 bankruptcy caters to unsecured debts, discharging them within 3-4 months. Most property may be exempted from sale to creditors by state law, but you’ll first need to pass a means test to see if you qualify for Chapter 7.
Chapter 13 is better for non-dischargeable debts like student loans and child support. It’s also more helpful if you have a car with a high interest rate or want to catch up on your home mortgage. Unlike credit cards, these are debts secured by property like vehicles and real estate. But to qualify for Chapter 13, you’ll have to have enough disposable income to commit to a 3–5-year repayment plan.
Don’t rely on these oversimplifications. Read more about Chapter 7 versus Chapter 13 bankruptcy in Upsolve’s free library. Also, remember that bankruptcy is not for everyone. Although debtors benefit from an automatic stay on collection and discharge from debts, this process comes at a price. Chapter 7 can stay on your credit report for 10 years and Chapter 13 for 7 years. Compare other debt-relief options with bankruptcy and weigh the pros and cons of all debt management plans before deciding on a plan of action.
Carrying too much debt not only keeps you from accomplishing your goals but also lowers your credit score. This makes it harder to get loans with favorable terms and low interest rates. Because your credit payment history and how much you owe make up 65% of your credit score, you can see how defaulting on loans and maxing out credit cards (or having a high debt utilization ratio) may harm you.
If you have too much debt and can’t use any of the debt repayment or relief options above, filing for bankruptcy may be a good option. But even filing for bankruptcy carries a cost. Fortunately, Upsolve has helped many eligible people file simple bankruptcy cases for free without an attorney. Upsolve can also connect you with a local bankruptcy lawyer to handle more complex cases.