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 (we get to that in the next section). We’re 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 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. $20,000 ÷ $40,000 = 0.5, or 50 percent The financially healthy amount of bad debt is zero. While enjoying the convenience of credit cards, never buy anything with your credit cards that you can’t afford to pay off in full when the bill comes at the end of the month. Not everyone agrees with us.
One major credit-card company says — in its “educational” materials, which it “donates” to schools to teach students about supposedly sound financial management — that carrying consumer debt amounting to 10 percent 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? In the “Analyzing Your Savings” section later in this chapter, we help you figure out how much you’re actually saving, and in Chapter 4, we help you determine how much you need to save to accomplish your goals.
(See Chapter 15 to find out how much mortgage debt is appropriate to take on when buying a home.) 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.