How much debt is too much debt? How do you measure up?

Posted by admin on July 8, 2008 in Misc.

In 1788, the House of Bourbon, rulers of France over 200 years, discovered their decadent and wasteful ways had made them broke. No one would lend them any more money. For the first (and last time) in over 400 years, the French Monarchy decided to draw up a budget. It wasn’t pretty. France’s expenses were greater than its revenue by 20%! The leading cause of this mess? Nearly 50% of their revenue was used to pay interest on their debt incurred which tied up all financial flexibility. An attempt to tax men of property, the nobility, set off a chain of events which lead to the French revolution and the overthrow of the French Monarchy. In other words, debt can literally bring down kings.

Today, we live in an age of debt that would make King Louis XIV blush. Collectively, we have negative savings rate. MSN Money reported an average American carries of 7.8 credit cards. We don’t blink taking out 40 year mortgages. Is our level of debt management completely out of control? What is the norm anymore? How do you measure up to the debt-saddled Jones (not a contest you want to win!)?

The Ideal Debt Ratios- the rule of 29/41

The Federal Housing Administration (FHA) insures mortgages in the United States for qualifying financial institutions. In an ideal scenario, FHA recommends the rule of 29/41. The 29% is a reference to the Front End Ratio which is a ratio found by the taking the cost of carrying your home monthly (mortgage, taxes, insurance) and dividing it into your tax-home pay. For example, assume your tax-home was $4,000/month. According to FHA, you ideally should not be paying for more than $1,160 month to carry your home. In the good old days of 2006, many lenders were willing to push the front end ratios to 33%-35% on account of rising housing prices.

The 41% is a reference to the Back End Ratio which is a ratio found by taking the cost of all your recurring debt (the cost of carrying your home, car loan, student loans, interest on lines of credit etc). and dividing it into your tax-home pay. According to FHA, and using the same example, above, your back end ratio should not be more than $1,640/month. Most lenders would accept a borrower with a back end ratio pushing 45% (now you know why the Bourbons couldn’t get a loan).

If you exceed both the front end and back end ratio, it is not the end of the world but it compromises your ability to weather any stormy financial weather.

What is the Ideal Level of Debt as Dollar Figure?

It depends. For mortgage debt, the Millionaire Next Door found that anyone wanting to achieve financial independence had to purchase a home that requires a mortgage that is NO more than twice the household’s annual realized income (all sources of income). In the go-go real estate boom of this decade, this did not buy you too much house considering the median salary of Americans was approximately $55,000. Hence, many became house-poor.

In Canada, Stats Canada reported that the average size of a mortgage in Canada was $90,000 in 2005 which doesn’t seem that bad but when you consider that an average male earned $42,700 and female earned $27,300 that year there are a lot of people who are breaking the Millionaire Next Door rule (source is again Stats Canada).

For credit card debt, the Federal Reserve reports that credit card balances typically average about 5% of a family’s average salary (as a research note, the Federal Reserve tends to underplay the level of consumer debt). But, the Federal Reserve also found that 50% of households had no credit card balances which seems to suggest that credit card debt is highly concentrated in households with out of control spending habits rather than spread uniformly across all households. There may be hope for us all after all.

How much is too much debt for a business?

If you are investing in stocks, Buffet’s rule is never to invest in a business that has long term debt which are 5 times more than annual earnings. Lots of debt impairs a business’ ability to seek grow, increase cash flow, pay or increase dividends and be competitive. In other words, all the things investors are looking for in a good stock.

If you run a business, this is not a hard and fast rule to follow given that most small businesses run up expenses to limit taxable income so earnings are not an accurate base in which to peg debt ratios. Most financial institutions will require debt-to-equity ratios between 1:1 to 1:2 to keep operating loans in good standing (shareholder loans are generally counted as equity in small business loans; in other words, if you have equity of $100,000 in a business, you are most likely eligible for a loan of no more than $200,000 but this depends on the industry and program). However, I would suggest this- since most entrepreneurs put in their own money into their business- try not to put more than 2 to 2.5 times your profits (add your draw into profits since taxable income is always lower in a private enterprise than public one) into the business as a safe cushion. It is extremely hard to earn that money back once you get above this threshold.

How do I control debt?

Separate needs from wants.
Pay down your highest interest debt first (sometimes paying down the mortgage is not the best move if your student loan has a higher carrying cost).
Only take one credit card out with you and have the self-discipline to never put more than 50% of the credit limit on the card (helps improve your credit score as well).
Formulate a plan (hire a money coach to help you draft one) on how you plan to attack your debt and have an accountability partner/buddy help you keep to the plan. Stay positive throughout.
Reward yourself for meeting goals

Good luck.