Here's how much you can afford to pay off debt

7 minutes
Here's how much you can afford to pay off debt

Select's editorial team works independently to evaluate financial products and write articles that our readers will find useful. If you click on links, we can earn commissions when you buy products from our affiliate partners.

Debt is complex. Sometimes taking on debt seems like a good idea, say when you borrow a mortgage to buy a home or use student loans to pay for your education. They can help you grow your net worth; on the other hand, it can quickly turn negative when you get stuck with high interest rates or borrow money to pay for things that you ca n't actually afford. Unfortunately, it can be difficult at times to know the difference between good and bad debt because everyone with a good credit score, positive income and favorable payment history can usually get a new credit card, take out a personal loan or buy a car with no money down. With so many opportunities to finance items, today's consumers need to be savvy. In order to help you evaluate how much debt you can actually handle, we talked to Albert's financial planner and head of advice Vadim Verdyan. Ahead, Verdyan shares with Select a few key factors to consider if you 're trying to find out whether you can actually afford more debt. How do you determine your debt tolerance?

It is almost impossible to know whether someone can afford a new loan or an increased credit limit based on how much they make in income alone, because different people will have different living expenses.

Lenders use a standardized calculation called debt-to income ratio to gauge whether a loan applicant has the space in their budget to borrow more money. DTI is calculated by comparing your total monthly debt payments with your monthly income. The equation includes housing costs and any outstanding minimum payments on any other debts of any kind. If you have a good monthly salary and would like to receive the minimum payments on your credit cards, student loans and car loans is$ 2,000, then your DTI calculation would look like this:$ 2,000$ 4,000 0.5 To multiply the ratio as a percentage, you would then get 0.5 x 100 50% Your DTI is 50%; an ideal DTI is no more than 36%, says Verdyan, though some qualified mortgages are available to borrowers with DTIs as high as 43%. Lenders typically use your personal income to calculate your DTI, but Verdyan advises against that when you do your own gross calculation. I suggest people gauge their net income on their DTIs, he says. Think about it: You 're not going to be using a big part of your paycheck, since it goes to taxes, social security, health insurance and so on. Using gross income does n't really give you a realistic picture of your actual budget. If you are looking to borrow money, make sure that your monthly bill wo n't exceed 36% of your take-home payment. If you want to be more conservative, do n't go above 30%; that way you will have at least 70% of your paycheck in the bank to cover the rest of your bills as well as some cash free to save for future expenses. If you 're thinking about making a big purchase on a credit card, like a 0% APR card, with a plan to pay it off over several months, do n't forget about your credit-utilization rate. Credit utilization looks at how much you owe each month compared to your credit limits across all major credit cards. If you have, for example, three cards, each with a credit limit of$ 3,000, your total credit limit is$ 9,000. A$ 3,000 purchase would equal one-third of your total credit utilization, so your CUR would be 33% until you pay it off. It's not always a bad idea to charge big items on a credit card, especially when you can take advantage of 0% financing or meet the minimum spending requirement to earn a generous welcome bonus.

But charging a big-ticket item is going to temporarily increase your CUR and cause your credit score to drop. Once you pay the balance off, your score will improve but you should n't raise your CUR right before applying for a new job or even when searching for a new job because you want your credit score to be good in case a credit check is part of the application process. Verdyan recommends using credit cards for 300% or less, says Henri to keep the rate of 30% or less. Others suggest even lower, recommending that your CUR be 10% or less. However, since credit cards generally charge a higher interest rate compared to a personal loan or home equity line of credit, it is not always the best financial decision to spend over 30% of your credit limits just because it's available. Add to the total cost of the debt ( the balance of the debts). The more money you borrow, the more you have to pay interest charges and fees in a year. Always check the interest rate on any kind of credit or loan product before you apply. Break it down into daily or even monthly fees to gain perspective as to just how much your debt actually costs. Also consider early costs like origination fees, hidden payback penalties and more. If you 're refinanced or even taking out a loan, use an interest calculator to see how much you pay in interest over the lifetime of the loan.

Try to improve your credit score before applying to borrow any type of product so that you can qualify for the best rate and save.

Putting aside the financials, you also want to take time to consider your personal feelings about money, borrowing and debt. There is an old saying: work a plan and have the plan. Some people know instinctively that they are savers, meaning they do n't buy anything until they have enough cash in the bank to cover it. Others know they ca n't lose sleep if they have debts. Psychologists could debate for ages about what makes certain people more risk averse than others. For your wallet's sake, it's worth thinking about where you fall on the spectrum from spender to saver.

When making a decision about taking on more debt, you will also want to think about where you are at this moment in your life and where you want to be several years from now. Someone in their 20s can arguably afford to take more risks when it comes to borrowing and investing, since they have more time to correct their course if they make a few mistakes along the way. But just because you can afford to take risks does n't mean that you should be all-around reckless. If you decide to do more debt, you should always have a plan to pay it off. And then stick to that plan; whether it's borrowing student loans, using a 0% APR credit card to finance a major purchase, taking out a personal loan to pay for an online certification or anything else, it is important to see how these additional payments will affect your budget and consider the longer term costs before you commit to more debt. Opinions, analyses, reviews or recommendations expressed in this article are those of the select editorial staff and have not been reviewed, approved or otherwise endorsed by any third party.

  • Comments
Loading comments...