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.
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.
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