How Much Debt is too Much


With interest rate being at a low due to the Federal Reserve taking measures to keep the economy afloat during a CoVID induced pandemic, debt has started to become what we would classify as "free money." A good example of this is an individual who earns over $200,000 and takes on a $141,000 mortgage with an 80% LTV and 2.625% interest rate. Without considering any rental income from this property, if you simply deduct the interest expense for this individual who is in the 35% marginal tax bracket, the true interest rate after-tax savings is 1.706%. When you then consider that the US has had an average inflation rate since the year 2000 of 2.165% (median of 2.2%) and we know real estate is an edge against inflation since the prices of homes generally rise in a good market on average, then the 1.706% true interest rate after-tax savings ends up being "free money." 

With these factors in mind, now might be a great time to take on debt but then raises the question of how much debt is too much? We will look at this from different points of view. One way to look at this is from an Asset to Liability ratio. Another is looking at the monthly income (after all fixed expenses have been accounted for) to the monthly interest expense ratio. The final way is to consider factors such as the opportunity cost of taking on such a debt. These could include quantitative factors such as the rate of return as well as qualitative factors such as peace of mind.

Asset-to-Liability Ratio

Your asset-to-liability ratio can simply be calculated by taking your total assets (cash, homes, investment accounts, and any tangible asset that can be valued and sold) and then dividing that by your liabilities (mortgage, personal loans, student loans). The resulting ratio is a multiplier. The larger the number, the better. An asset-to-liability ratio of infinity indicates that an individual has zero debt. This particular case would be individuals who are risk-averse or nearing the age of retirement and qualitatively put more value towards having peace of mind. 

Evaluating the amount of risk as one age - I would expect the older one gets, the increase in asset-to-liability ratio due to a decreased risk tolerance. Low-risk assets e.g. CDs and Bonds typically are not used as leveraged assets. Because of this trend, my recommendation of an asset-to-liability ratio is highlighted below:

Within the early 20s of an individual, a recently graduated college student will more likely have on average about ~$30,000 in student loans. In order to achieve a ratio of 2, then about $60,000 in assets is required. Once in the late 20s, the value of the assets would have to be increased to achieve a ratio of 3.0. Although most Americans are probably below the ratio of 3.0 in their late 20s, they have a chance to catch up in their 30s with an increased focus towards financial health. Between years 30 and 40, this is the stage where families are typically created with a family of 3-4 on average. Given the increased expenses from having children, even after factoring the standard tax deduction for each child, as well as taking on a mortgage, it can be difficult to achieve a ratio >4. However, at this point, we can make an assumption that both parents actively contribute to their 401k retirement portfolio and own a home that appreciates in value each year. Accounting for the annual return of 7-10% in the market and additional income earned between the late 20s and well into the 30s, we would anticipate that the asset value would have increased substantially increased resulting in a ratio >4. As one becomes more risk-averse and has the kids out of the house in their 50s-60s, then the ratio should get a significant boost well into retirement.

A quick example of how to compute the asset-to-liability ratio is a case where we could assume an individual has a total asset of $1.92MM consisting of stocks and real estate. With this amount of assets, comes a liability of $594,000 predominantly driven by a low-interest mortgage balance. Dividing both numbers together, a ratio of 3.23 is calculated.

Income-to-Interest Expense Ratio

The second way of analyzing how much debt is too much can be done using an income-to-interest expense ratio. The main goal here is to make sure the debt interest payments can be fully serviced without discomfort even when accounting for unforeseen circumstances. 

As an example: assuming a 30-year mortgage of $594,000 at a 2.75% interest rate. The monthly interest payment equates out to be about ~$2,500 per month. Using an annual income of $200,000 and then subtracting yearly expenses of $30,000 as well as a tax bill of $25,000. The take-home income comes out to be $145,000. In this situation, the debt service is about $2,500/month and the take-home income is about $12,000/month. This individual is more than capable to service the debt using the regular income. We can also consider a scenario where the income is slashed by 50% to $100,000. The monthly income becomes $7,500/month which also more than covers the debt. Furthermore, the beauty of acquiring assets is the fact that the assets can be used to generate a return. This additional income can be used to fully cover the interest payment which is a benefit.

Peace of Mind

The last way of analyzing how much debt is too much is simply considering the peace of mind. When one does not want to deal with the hassles of making sure payments are made on time and in the right amounts then it might be time to hang up the boots. Peace of mind is a qualitative factor and the value placed on it differs from person to person. It is a more introspective value and should be thought about carefully. Typically, when one is nearing retirement - it might be more important to eliminate all debts.

Financial Savant was born in 2018 and has received a really good reception so far. This blog serves as a resource to help spur open discussions on generating income, saving, investing, and overall wealth management.

Every article written on Financial Savant is based on first-hand experience and pertain to ongoing current events within the financial and economic-sphere.

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