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Those in the anti-debt or anti-credit card set often argue that any amount of debt is too much. But having a credit history (which comes from accruing and paying off debt) saves you money and makes modern life more convenient.
Without a credit history or a credit card, you may have to pay more or may even have trouble:
- Buying a house
- Renting a car
- Securing a good job (at places where employers check credit history)
- Renting an apartment
- Buying a car
- Getting a cell phone
Of course, in most situations, if you have enough cash you can get what you need — and that includes a house. But most people wouldn’t want to liquefy most of their assets to purchase a home with cash, for instance.
There’s a fine line between having credit cards and paying them off in order to establish a credit history and raise your credit score and having too much debt, which causes stress and financial struggles. But how much is “too much” debt? First, let’s look at the factors that go into calculating your total debt.
In order to qualify for a mortgage or another loan, most lenders want to see a 28/36 DTI (debt-to-income) ratio. This means that the money you pay toward housing each month should be no more than 28% of your gross monthly salary, while your other debt (including car loans, student loans, credit card debt and some fixed expenses) should equal no more than 36% of your gross monthly salary.
This is a good guideline to keep yourself out of financial trouble, but there’s more to the story.
The credit elite among us, those with FICO credit scores in the 800 + range, often boast a debt-to-available credit ratio of just 2 or 3%. In general, lenders want to see that the amount of your credit card debt in relation to your available credit (sometimes called your credit utilization ratio) is below 30%. Anything greater than 50% can really hurt your credit score.
I recently increased my credit score by 12 points in one month (through the Quizzle Credit Personal Trainer) by paying down one of my credit card balances so it was below 50% of the available credit on that card.
When you look at your credit utilization ratio, look at your overall debt compared to your overall available balances, as well as the ratio on individual cards. My credit score took a hit during the holiday season when I charged up my rewards card very close to its available balance, even though I paid it off the next month. Had I realized this beforehand, I would have made payments immediately after I made a purchase, rather than waiting until I finished all my holiday shopping. (I did this in order to track my total spending easily and not go over budget.)
Your “high balance” on each credit card — that is, the highest your balance has ever been on a given credit card — also shows up on your credit reports. If this number is very close to your available credit, it could be a red flag to lenders.
If you are working to pay down debt and you have one card with a very high balance compared to your credit limit, it makes sense to get that card down below 50% debt-to-available credit (and make the minimum payments on your other cards) before focusing on other credit cards, regardless of the interest rate. This will improve your FICO score, which can help you in other ways, with lower interest rates, balance transfer offers and additional savings opportunities.
Revolving debt, such as credit card debt, can cost thousands in interest payments over the years and is often avoidable. On the other hand, mortgage payments are practically an unavoidable fact of middle class life. Student loans, in theory, will pay for themselves by resulting in a higher salary when you graduate. And if you’ve been shelling out thousands of dollars in car repairs each month, it might make sense for you to buy a new car with a car loan, rather than spending cash on a lemon. (If you’re putting the car repairs on a high-interest credit card, definitely consider a new car rather than digging yourself deeper into credit card debt.)
A diverse credit portfolio actually increases your credit score, so having a handful of credit cards, a car loan and a mortgage will actually help you obtain a higher FICO score. (And we know the benefits of that, now…)
It’s important, when you look at your debt picture, to ask yourself a few questions:
- What kind of debt do I have? (If most of your debt is revolving credit card debt, this could be a problem.)
- Can I manage my monthly payments consistently?
- Can I afford to pay more than the minimum payment so that I can pay off my debt faster?
- Does having this debt cause me stress?
- How much am I paying in interest because of this debt? Is there a way I can reduce my interest charges?
Only once you evaluate the answers to these questions can you really decide if you have too much debt or not. When you truly understand your financial situation, you’ll be in the right place to improve it.