Debt is a wealth killer for sure, especially if a good chunk of your income is going toward minimum payments each month instead of your savings account. Carrying a lot of debt can also drag down your credit score, which makes it harder to qualify for the best terms and rates when applying for new financing.
But how much debt is too much? Here are five red flags that you've bitten off more than you can chew - and tips for getting a handle on it.
1. You can only afford your minimum payments
Being stuck in a just-pay-the-monthly-minimum cycle is a pretty good indicator that you're in over your head debt-wise.
"One of the first signs that an individual's debts are getting out of control isn't missing a payment, it's letting an account balance get to the point that they can't pay it down within three to five months," Martin Lynch, a certified credit counselor and director of education at Cambridge Credit Counseling Corp., tells LendingTree.
Paying the bare minimum each month isn't much of a strategy since you'll shell out significantly more over the life of the balance, thanks to the interest. Let's say you have a $3,000 credit card balance with an 18% APR and a $100 minimum payment. If you only pay the minimum, it'll take you 41 months to eliminate the balance - and you'll pay over $1,000 in interest.
But if you double your payment to $200, you'll shave $592 off your interest fees and be debt-free in just 18 months. The numbers get even better if you opt for a 0% introductory balance transfer offer, which we'll dive into shortly. The main takeaway here is that if your budget doesn't allow you to accelerate your debt payments beyond the minimum, it's time to make a plan.
2. Your credit cards are maxed out
One of the most important factors in determining your score is your credit utilization ratio. This highlights exactly how much of your available credit you're actually using. If you've currently maxed out more than 30% of your credit lines, your credit score will take a hit because it suggests that you're unable to responsibly manage your debt.
Maxing out your cards means you have zero available credit, which will send this ratio through the roof.
It is a teachable moment, though - why are your cards maxed out? Is it to cover basic living expenses like groceries? Have you reached for plastic to cover impulse purchases like unplanned shopping trips or last-minute vacations? These are pretty good indicators that you're living beyond your means.
The good news is that creating a solid budget can prevent you from going further into the red. In the meantime, Lynch suggests pressing pause on new credit purchases until you regain control of your finances.
"If you find yourself in a deepening hole, stop digging!" he says.
3. Your debt-to-income ratio is above 36 percent
Interest rates aside, you can also determine if you have too much debt simply by looking at how your total monthly payments relate to your income. This is aptly known as your debt-to-income (DTI) ratio. To figure it out, add up all your monthly minimum payments and then divide that total by your gross monthly income. What you're left with is your DTI - 36 percent or less is the ideal situation.
When it comes to applying for new financing, a high DTI can come back to bite you - especially if you're applying for a home loan. If a new housing payment would put your DTI at 43 percent or higher, it sets off alarm bells to most mortgage lenders. Even if you have no intention of buying a home anytime soon, your debt-to-income ratio is still a great way to take your financial temperature. If it's on the high side, treat it like a warning sign.
4. Your interest fees exceed 20 percent of your income
Diana Bacon, a Dallas-based certified financial planner and senior wealth adviser, says figuring out if you have too much debt is as easy as crunching a few numbers. Begin by tallying up how much you're paying in interest charges across all your debt, from auto loans to student debt to credit card bills. If it's more than 20 percent of your monthly take-home pay, you're in trouble.
"If we're talking exclusively about credit card debt, that number should be well below 20% because those interest rates are just so high," she tells LendingTree.
5. You're struggling to build an emergency fund
"Cash savings is the best way to avoid the credit card cycle," says Bacon, who suggests setting a target that's equal to at least three months' worth of expenses.
This should keep your head above water if you're hit with an unexpected job loss or bill, but building an emergency fund doesn't happen overnight. It's a gradual process that instantly becomes harder if a large chunk of your income is going toward debt payments.
But you can only stretch your money so far - unfortunately, this only strengthens the debt cycle. If you have no emergency fund and you're hit with, say, a $600 car repair, you'll end up turning to a credit card to see you through. One bright spot, though: you don't have to choose between paying off debt and building your emergency fund. It's possible to do both if you leverage the right strategies. Be that as it may, if account balances are a hurdle between you and a healthy savings account, that's a major red flag.
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