Household Debt – How Much Is Too Much?

One of the big personal finance stories of the past week is that American households once again have approximately as much household debt as they did before the financial crisis. However, when you read past the headlines, you can see that personal balance sheets are much stronger than they were (on average) in 2008. Here’s why:

The amount of household debt is relative:

The total amount of household debt is around the same level as it was in 2008 ($12.58 billion). However, simply looking at the total household debt by itself ignores inflation, income growth, and growth of the overall economy since 2008. In fact, the population has grown by 20 million people since then and household debt as a percentage of the overall economy (GDP) is near its lowest level since 2002.

Click to enlarge

Debt payments as a percentage of income have fallen: The percentage of household income that Americans currently spend on debt payments is near its lowest level in 35 years. The average household spends approximately 10% of disposable income on debt payments compared to around 13% before the financial crisis. As reported in our article “Debt to Income Ratio – It’s Affect On Your Finances”, the maximum debt to income ratio that banks will lend for a mortgage is 43%!

Stronger Borrowers:

A greater portion of household debt is held by older borrowers, who tend to have more stable incomes and lower default rates. Also, the median credit score for new mortgages these days is over 760, and it recently reached 700 for new auto loans. The stricter lending standards were formalized in January of 2013 when the Consumer Finance Protection Bureau released its “Ability to Repay” and Qualified Mortgage” rules. These rules require lenders to consider and verify eight different underwriting criteria and virtually eliminated interest only loans, negative amortization loans, stated income and no doc loans.
How much debt is too much?

How much household debt is apppropriate?

There is no consensus among well-known financial planners on the appropriate or recommended amount of debt. It ranges from Dave Ramsey’s recommendation of no debt to Ric Edelman’s advice to take out the biggest mortgage you can and never pay it off. My personal philosophy falls somewhere in between. My advice for young folks would be to take out a mortgage and try to pay it off by the time they retire. This gives folks the mortgage interest deduction while they are working, acts as a form of forced savings, and gives retirees the opportunity to downsize or take a reverse mortgage if they need to tap home equity in retirement to supplement their incomes.

My other personal philosophy on debt is “Never borrow money for a depreciating asset.” This includes cars loans. Many people would argue that it makes sense to finance if you are offered 0% (or some other ridiculously low rate). Mathematically, this may be true, but the purchase price is a much bigger issue than the interest rate. It is much less likely that you will overspend on a car if you are paying cash. It is more difficult to justify spending $50k vs $30k than it is to agree to a monthly payment of $750 vs. $500. I feel more strongly about this advice (never borrow money for a depreciating asset) when speaking to younger folks (pre-retirement). Retirees have a better feel for how much car they can afford, and their income and expenses tend to be more stable and predictable.