How to recognize bad debt overload

Calculating how much debt you have relative to your annual income is a
useful way to size up your debt load. Ignore, for now, good debt — the loans
you may owe on real estate, a business, an education, and so on.
I’m focusing on bad debt, the higher-interest debt used to buy items that
depreciate in value.

To calculate your bad debt danger ratio, divide your bad debt by your annual
income. For example, suppose that you earn $40,000 per year. Between your
credit cards and an auto loan, you have $20,000 of debt. In this case, your bad
debt represents 50 percent of your annual income.

bad debt
----------------     = bad debt danger ratio
annual income

The financially healthy amount of bad debt is zero. Not everyone agrees with
me. One major U.S. credit card company says — in its “educational” materials,
which it gives to schools to teach students about supposedly sound
financial management — that carrying consumer debt amounting to 10 to 20
percent of your annual income is just fine.

When your bad debt danger ratio starts to push beyond 25 percent, it can
spell real trouble. Such high levels of high-interest consumer debt on credit
cards and auto loans grow like cancer. The growth of the debt can snowball
and get out of control unless something significant intervenes. If you have
consumer debt beyond 25 percent of your annual income, see Chapter 5 to
find out how to get out of debt.

How much good debt is acceptable? The answer varies. The key question is:
Are you able to save sufficiently to accomplish your goals?

Borrow money only for investments (good debt) — for purchasing things that
retain and hopefully increase in value over the long term, such as an education,
real estate, or your own business. Don’t borrow money for consumption
(bad debt) — for spending on things that decrease in value and eventually
become financially worthless, such as cars, clothing, vacations, and so on.

Difference between Bad Debt and Good Debt

Why do you borrow money? Usually, you borrow money because you don’t
have enough to buy something you want or need — like a college education. If
you want to buy a four-year college education, you can easily spend $100,000,
$150,000, or more. Not too many people have that kind of spare cash. So borrowing
money to finance part of that cost enables you to buy the education.

How about a new car? A trip to your friendly local car dealer shows you that
a new set of wheels will set you back $20,000+. Although more people may
have the money to pay for that than, say, the college education, what if you
don’t? Should you finance the car the way you finance the education?

The auto dealers and bankers who are eager to make you an auto loan say
that you deserve and can afford to drive a nice, new car, and they tell you to
borrow away (or lease, which I don’t love either). I just say, “No! No! No!”
Why do I disagree with the auto dealers and lenders?

For starters, I’m not trying to sell you a car or loan from which I derive a
profit! More importantly, there’s a big difference between borrowing for something
that represents a long-term investment and borrowing for short-term
consumption.

If you spend, say, $1,500 on a vacation, the money is gone. Poof! You may
have fond memories and even some Kodak moments, but you have no financial
value to show for it. “But,” you say, “vacations replenish my soul and
make me more productive when I return. In fact, the vacation more than pays
for itself!”

Great. I’m not saying that you shouldn’t take a vacation. By all means, take
one, two, three, or as many as you can afford yearly. But that’s the point:
Take what you can afford. If you have to borrow money in the form of an outstanding
balance on your credit card for many months in order to take the
vacation, you can’t afford it.