How Much Debt is Too Much?

Given that 80% of all Americans are in some form of debt and the US national debt has eclipsed $22 trillion, I thought it might be a good idea to discuss how much debt can be too much. It should be worth pointing out that not all debt is “bad debt”. Debt that is used to generate income substantially greater than the interest being paid is classified as “good debt.” There is a popular term called the cost of capital used by companies as a benchmark to measure how well any investment performs. You can think of the cost of capital as the minimum rate of return required to generate economic value. Most companies have to raise capital somehow and they can either be raised through debt financing or equity financing. Whichever route they choose to raise capital does have a cost of capital that can be determined based on the historical risk profile of that company and opportunity cost of available risk free rate instruments (usually the treasury bond). Obviously an investor should be aware of this cost of capital since it impacts investment decisions.
A key financial metric used to evaluate companies is a term called the “net debt to EBITDA” sometimes called leverage ratio. This in simple terms is the ratio of the amount of debt to the net income the company brings in before interest, taxes, and depreciation are factored in. Usually a net debt to EBITDA less than 0.5 is a very healthy range for a company. Companies within this healthy range have stronger balance sheets and generate a tremendous amount of cash flow with very little total debt. Facebook is an example of such a company since Facebook has an extremely low amount of debt to EBITDA. On the other spectrum, companies with a very high leverage ratio most likely have to finance projects through debt since their operating cash flows are generally much lower and in some cases constantly generate negative free cash flow.
To translate this over to the regular American – the average American has $38,000 in personal debt with credit card debt consisting of 25% of all debt. Credit card debt is considered “bad debt” given the fact that the median credit card APR is 21.23%. You can think of 21.23% as the cost of capital of using a credit card to fund a project since that percentage usually has to be paid back. Since credit card debt is “unsecured” meaning that it is backed by the borrower’s promise to pay which is much different from secured debts that are backed by collateral, I tend to think of a credit card’s APR as more similar to cost of equity other than cost of debt. I probably am giving too much adulation to taking on credit card debt since that debt is not typically not used to generate income, instead credit cards are used for entertainment purposes or to cover basic expenses.
Now, how much debt is too much? Similar to net debt to EBITDA used to assess a company’s financials, a debt-to-income ratio is used to assess how healthy an individual is financially. The debt-to-equity ratio is simply the monthly debt payments divided by the gross monthly income. An individual with a debt-to-income ratio greater than 43% or 0.43 will have a difficult time taking out a loan. Lenders use this cut-off to determine if they can qualify that individual for a mortgage. Most financial advisors say a debt-to-income ratio greater than 20% is not ideal. It is also important to be aware of the interest rate being charged by the debt collector as a 4% interest mortgage is extremely different from a 21% interest credit card. I have outlined the steps to take to get rid of debt and hope you find as a useful resource.
Another resource that helps put your amount of debt in context with the general population is Status Money. It is free tool that shows peer comparisons including income, spending, credit profile, assets, debts, and net worth. A percentile rank is also calculated with where one falls within each peer group and the national average. The tool offers other benefits outside of just peer comparisons, you can analyze your cash flows and view future projections based on your transaction patterns. You find out if your interest rates are higher than the rates of people with similar scores. This is valuable as this can lead to a recommendation of refinancing your mortgage for example and possibly save you hundreds of dollars. Finally, Status Money gives actionable insights by recommending personalized opportunities to save, earn smarter, and grow your net worth.


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