Almost everyone carries at least some form of debt. In the first quarter of 2017, consumer debt in America hit an all-time high of $12.73 trillion. Household debt continues to grow every year, alongside federal and corporate debt. In other words, the country is swimming in borrowed capital.
This isn’t necessarily a bad thing. Debt of any kind can actually be beneficial if it’s used responsibly. Borrowed money can help save you time and effort in several situations, from buying a house, getting educated, or starting a new business. A quick loan from Cash Stop can help you meet your monthly expenses, buy that new car, or purchase a new piece of tech. Debt can certainly be useful in moderation.
By borrowing a sustainable amount, you can fund your dreams and complete important projects without messing up your credit score or your personal finances. Here’s how you can figure out how much money you can borrow safely:
Total Net worth
In order to borrow safely, it’s important to estimate your ability to pay back the loan. A crucial factor is your net worth. Your personal net worth is the estimated value of all your assets, minus the estimated value of everything you owe. In other words, it’s the net value of everything you possess.
When total debt is measured as a ratio against your net worth, it provides a clearer structure to your personal finances. As a rule of thumb, the lower the debt-to-net worth ratio, the more sustainable the debt.
While a debt-to-net worth ratio of less than 1x is ideal, any ratio below 2.5x would be considered relatively safe.
Interest Coverage
Another, and more precise, way to calculate debt sustainability is the debt-to-income (DTI) ratio. By measuring gross monthly income against your net debt expenses you can accurately estimate your ability to service the debt load.
Experts disagree on the ideal ratio of debt expenses to income. However, a good place to start is the recommended ratio for qualified mortgages.
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, lenders, banks, and financial institutions can offer borrowers special protections and terms if the debt expenses or monthly interest payments are less than 43% of monthly gross income. This means a debt expense-to-income ratio of less than 0.43 would be considered safe. For home loans and mortgages, financial planners recommend keeping this ratio below 0.30.
In short, spending less than one-third of your pre-tax income every month on all your interest payments is financially sustainable.
Final Thoughts
The wealthier you are the more you can borrow. Your total wealth and gross income are important factors to consider when estimating how much money you can borrow. Banks and lenders have specific ratios in mind when they offer to extend a loan. Sticking to these ratios makes it more likely that your debt will help you grow, rather than put you in a detrimental, stressful position.
