How Much Debt Can I Afford?

At some point in our lives, most of us will have to borrow money; whether to pay for a house, a college education, a car, or some other major expense. Not all debt should be avoided, because sometimes strategically borrowing money can help us save money or make more money in the long run.

But we’ve all heard about the dangers of borrowing too much. If you take on too much debt, you’ll likely be unable to save much for retirement or personal emergencies, so any sudden or unexpected loss of income or expense (like losing your job, or having a medical emergency) could ruin your finances for a long time.

So how much new debt can you afford?
There are a number of calculations to make but the first step, after you’ve determined your “gross monthly income” (which is simply your monthly salary or total wages, before taxes), is to calculate how much you have available each month to pay down any new debt.

Start by writing down all the expenses you pay each month from your after-tax income. Include any existing debt obligations (like credit cards or prior student loans), and expenses that you might not pay close attention to, like your mobile phone bill, Sky TV, gym memberships, electric bills, amounts you regularly contribute to, retirement plans and savings, etc. Once you subtract these costs, you’re left with the amount that you could potentially afford.

Why Are You Borrowing?
The next step depends largely on the answer to another question – why are you borrowing? If you’re borrowing for a home mortgage, your lender will calculate two different “debt-to-income” ratios, which helps them decide whether to approve your application. So these amounts should be considered the maximum you could borrow.

The first is called the “front-end ratio”. Lenders generally want your total mortgage debt (which should include any taxes and insurance) plus any condominium fees to be less than a certain percentage of your gross monthly income. This percentage is generally in the 28%-30% range. Second, the lender will want your “back-end ratio”, or your total monthly debt payments (including credit cards, student loans, etc.) to be less than roughly 36-38% of your gross monthly income.

When you buy a new house or other property, you also need to include in your budget both the one-time and recurring expenses that you’ll likely face as a new homeowner. These expenses often include moving costs, new furniture, cleaning costs, new appliances, and an allowance for maintenance and repairs.

This advice also applies to calculating how much of a loan you can afford for a new or used car. You’ll also face fuel, insurance, periodic maintenance and repair costs, so don’t leave those out of your calculations.

Dont’ Stretch Your Borrowing
Finally, don’t let yourself fall into the trap of borrowing the maximum possible within your personal budget. If you can borrow less, but still get what you want and need for in a house or car or education, you’ll have more money left over to save, which is always good for your financial future.

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