4 Ways to Determine Your Debt Tolerance

Debt is complicated. Sometimes, taking on debt seems like a good idea, say when you get a mortgage to buy a home or use student loans to pay for your education. Both can potentially help you grow your net worth.

On the other hand, it can quickly turn negative, when you get stuck with high interest rates or borrow money to pay for things you can’t truly afford.

Unfortunately, it can be tough to know the difference between good and bad debt at times, since anyone with a good credit score, stable income and positive payment history can usually get a new credit card, take out a personal loan or buy a car with no money down.

With so many opportunities to finance items, today’s consumers need to be savvy. To help you discern just how much debt you can actually handle (and why), we spoke to Albert head of advice, Vadim Verdyan.

Ahead, Verdyan shares with Select a few key factors to consider if you’re trying to figure out if you can actually afford more debt.

It’s almost impossible to guess whether someone can afford a new loan or an increased credit limit based on how much they make in income alone because different people will have different living expenses. Lenders use a standardized calculation called debt-to-income ratio (DTI) to gauge whether a loan applicant has room in their budget to borrow more money.

DTI is calculated by comparing your monthly debt payments to your total monthly income. The equation includes housing costs (whether you rent or own) and any other minimum payments on outstanding debts of any kind.

For example, say your rent/mortgage, plus the minimum monthly payments on your credit cards, student loan payments, personal loans and car loans totals $2,000 and your gross monthly income is $4,000, your DTI calculation would look like: $2,000 / $4,000 = 0.5. To get the ratio as a percentage, you would then multiply 0.5 x 100 = 50%. Your DTI would be 50%.

An ideal DTI is no more than 36%, says Verdyan, though some qualified mortgages are available to borrowers with DTIs as high as 43%. Lenders typically use your gross, or pre-tax, income to calculate your DTI, but Verdyan advises against that when you do your own personal calculation.

“I always recommend people gauge DTI off of their net income,” he says. “Think about it: You’re not going to be using a big portion of your paycheck since it’s going to taxes, social security, health insurance and so on. [Using gross income] doesn’t really give you a realistic picture of your actual budget.”

If you’re looking to take out a loan, make sure that your monthly bill won’t exceed 36% of your take-home pay. If you want to be more conservative, don’t go above 30%. That way you’ll have at least 70% of your paycheck leftover to cover the rest of your bills as well as any discretionary spending plus some cash free to save for future expenses.

If you’re thinking about putting a big purchase on a credit card, like a 0% APR card, with a plan to pay it off over several months, don’t forget about your credit-utilization rate (CUR).

Credit utilization looks at how much you owe versus your credit limits across all credit cards. If you have, for example, three cards, each with a $3,000 credit limit, your total credit limit is $9,000. A $3,000 purchase would equal one-third of your total credit utilization, so your CUR would be 33%, until you pay it off.

It’s not always a bad idea to charge big items to a credit card, especially if you can take advantage of 0% financing and/or meet the minimum spending requirement to earn a generous welcome bonus.

But charging a big-ticket item is going to temporarily raise your CUR and cause your credit score to drop. Once you pay the…