The first step when organizing your finances or starting any debt management plan is to fully understand your personal debt. Debt is money, goods, or services owed by an individual to someone else. Having debt can be a burden that is hard to overcome without the right strategies, so it is important to understand where debt comes from and how to manage it over time.
10 Common Causes of Personal Debt
There are many causes behind personal debt, but the 10 most common reasons include:
- Reduced income but the same expenses
- Divorce
- Poor money management
- Underemployment
- Gambling
- Medical expenses
- Saving too little or not at all
- No money-communication skills
- Banking on a windfall
- Financial illiteracy
Identifying your sources of debt can help you find areas to improve or costs that could be cut. As you can see, the reasons that debt exists in someone’s life may differ greatly from one person to the next. Some of these issues are out of our control, while others may be deemed irresponsible financial behavior. In either case, recognizing the good versus the bad when it comes to debt is a must.
“Bad Debt” vs. “Good Debt”
The above causes are the most common to contribute to the accumulation of what experts describe as bad debt.
This is the more common form of debt, and the one most Americans are familiar with. Bad debt is accumulated when people forgo using savings and instead use credit to buy disposable items or everyday goods. It includes credit cards, auto loans, or putting things on layaway. This type of debt is not looked upon favorably and is a common cause of stress in people’s lives.
On the flip side is good debt. If the debt is accumulated for a reason that is likely to produce value in the long run, it is commonly called good debt. It can include student loans, home mortgages, or business loans. All these types are looked upon favorably by creditors, and with good reason.
It’s important to remember that not all debt is bad. Even the debts listed above that are categorized as bad can be manageable, so long as you have enough to pay what you owe each month along with other non-debt expenses.
How Much Debt Should I Have?
Asking how much debt you should have is a common question to ask yourself when trying to understand your personal debt situation. One way to gauge where you fall in terms of your debt is calculating your debt-to-income ratio.
First, add up your monthly debt payments, including your mortgage (principal, interest, taxes, and insurance) and home equity loan payments, car loans, student loans, your minimum monthly payments on any credit card debt, and any other loans that you might have. Do not include expenses such as groceries, utilities, and gas. Take this total and divide it by your gross monthly income from all sources.
For example:
Monthly income: $6,000
Monthly debt: $1500
$1500/$6000 = 0.25
This gives you your debt/income ratio, which is 25% in this case.
Usually, you want to keep this number below 36%. Maintaining a lower debt-to-income ratio often means that your debt is manageable, given you have enough from income to cover other monthly expenses. However, if your debt has gotten to the point that it exceeds this level, or you are focused on getting out of debt, having the right strategies to do so is crucial to your success.
Next up, common debt consolidation options.
