The amount of debt you can consider "reasonable" will vary widely depending on a number of factors about your financial situation and the type of debt you have. You'll need to consider how you are using the debt and how you are able to pay it off, as well as the debt's impact on your overall credit.
Learn how to determine how much debt is too much and how much debt may be considered reasonable. Then, you can better analyze your own financial situation.
Key Takeaways
- Some debt may not be considered good if it helps improve your financial situation.
- Good debt may include a mortgage that can help you buy a home and build and asset.
- If you cannot afford to pay your minimum debt payments, your debt amount is unreasonable.
- The 28/36 rule states that no more than 28% of a household's gross income should be spent on housing and no more than 36% on housing plus other debt.
The Good Side of Debt
Debt can allow you to purchase useful assets that would otherwise be too costly. Taking on a mortgage to buy a home, for example, not only provides a family with a place to live but can, in the long term, prove to be a worthwhile investment.
This is not to say that you should constantly be taking on debt. A moderate amount of debt that helps your overall situation and is within your means to pay down may be considered a reasonable amount of debt.
Generally, what is considered a reasonable amount of debt depends on a variety of factors, such as what stage of life you are in, your spending and saving habits, the stability of your job, your career prospects, your financial obligations, and so on.
The interest rates that you're paying on your debt are another important factor in determining whether a debt is reasonable. A relatively low interest rate, such as those found on mortgages, makes debt manageable. On the other hand, high-interest rates, such as those on payday loans and some credit cards, can lead to debt levels spiraling out of control.
If you have an unmanageable amount of debt, you may want to consider using a debt relief company, which can help you negotiate with creditors to pay a lower amount. These companies work with unsecured debt in which you are significantly behind in payments.
Using the 28/36 Rule
A common rule-of-thumb to calculate a reasonable debt load is the 28/36 rule. According to this rule, households should spend no more than 28% of their gross income on home-related expenses, including mortgage payments, homeowners insurance, and property taxes. At the same time, they should spend no more than 36% on housing expenses plus all other debts, such as car loans and credit cards.
So, if you earn $50,000 per year and follow the 28/36 rule, your housing expenses should not exceed $14,000 annually, or about $1,167 per month, and your housing expenses plus other debt service should not exceed $18,000. That means your non-housing debts should cost you no more than $4,000 annually or $333 per month.
Further assuming that you can get a 30-year fixed-rate mortgage at an interest rate of 4% and that your monthly mortgage payments are a maximum of $900 (leaving $267, or $1,167 less $900, monthly toward insurance, property taxes, and other housing expenses), the maximum mortgage debt you can take on is about $188,500.
If you are in the fortunate position of having no credit card debt and no other liabilities and are also thinking about buying a new car to get around town, you can take on a car loan of about $17,500 (assuming an interest rate of 5% on the car loan, repayable over five years).
To summarize, at an income level of $50,000 annually, or $4,167 per month, a reasonable amount of debt would be anything below the maximum threshold of $188,500 in mortgage debt and an additional $17,500 in other personal debt (a car loan, in this instance).
Note that this example is based on early 2020s interest rates, which were at near-historic lows. Higher interest rates on mortgage debt and personal loans would reduce the amount of debt that can be serviced since interest costs would eat up a larger chunk of your available income.
Applying the 28/36 Rule to Take-Home Pay
The 28/36 rule is typically applied to gross income, as in the scenario above. Financial institutions also use gross income in calculating acceptable debt ratios, because net income or take-home pay can vary from one locale to the next, depending on state and local income taxes and other paycheck deductions.
But it can be safer to base your borrowing and spending habits on your take-home pay, since this is the amount that you actually have at your disposal after taxes and other deductions.
So, in the above example, assuming that income tax and other deductions reduce gross income by a total of 25%, you're left with $37,500 or $3,125 monthly. This means that if you follow the 28/36 rule, you could allocate $10,500 or $875 monthly to household-related costs and $250 to other debt, for a total of $1,125 per month or $13,500 annually.
What Is Debt Service?
Debt service refers to the amount of money a person or business must pay each month (or other time period) to cover their debts. If too much of a person's or a company's income is going toward debt service, lenders may not be willing to extend them additional credit.
What Is a Debt-to-Income Ratio?
Debt-to-income (DTI) ratio is a common measure used in consumer lending. It divides an individual's total monthly debt payments by their gross monthly income to arrive at a percentage. What constitutes an acceptable (or excessive) DTI can vary from lender to lender and by loan type.
What Is Debt Consolidation?
Debt consolidation is a process of taking on a new loan or other type of debt to pay off multiple existing debts. The goal of debt consolidation is usually to attain a lower interest rate, resulting in lower monthly debt payments.
The Bottom Line
Debt can be a financial benefit when it's managed properly and when it serves to help you build wealth. While your personal financial situation will ultimately dictate the amount of debt that's reasonable, the 28/36 rule provides a useful starting point to calculate a reasonable debt load. Consider consulting a financial professional to help you determine how debt can play a role in your finances.
