How Much Debt is Too Much?

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We’ve often heard from the banks and financial institutions that the key to getting rich is managing your debt responsibly. Debt, after all, is as much a part of modern day life as driving a car or tapping on a smartphone. It’s just the way things are.

Photo by Chris Potter @ Flickr.

And part of that conversation is the differentiation between “good debt” and “bad debt.” To recap, “good debt” is defined by the Financial Industry as debt that is used to buy something that goes up in value. Common examples given are a house or education. Meanwhile “bad debt” is defined as debt used to buy something that goes down in value. Credit card debt is the most obvious case.

And while we can all agree that credit card debt screws you over, isn’t it suspicious that those very same Financial Institutions that warn you that “credit card debt is bad debt!” will then turn around and sign you up for as many credit cards they possibly can? Why is that?

Because the banks are right about one thing: Debt IS the key to getting rich.


Photo by aisletwentytwo @ Flickr
Photo by aisletwentytwo @ Flickr

Think about this. Banks love to tell everyone what a wonderful investment real estate is. Housing always goes up, up, up after all! You can’t lose when it comes to real estate! If you don’t buy in now, you’ll never get in ever and you’ll be caught sitting on the sidelines missing out on the easy gains everyone else will get! It’s relentless. You can’t walk into a bank branch without having mortgage papers thrown at you.

So here’s my question: If real estate is such a sure-fire great investment, why don’t the BANKS buy it for themselves?

After all, they have the money. They ARE the ones giving out mortgages after all. If real estate is a surefire win, then they should want it for themselves rather than lending you money to buy it.

Here’s why: The Banks are lying to you.

Real Estate is NOT risk-free. Real Estate has gone south before, and will go south again. And when it does, the banks don’t want to be the ones losing money. No, they’d rather have someone else take the risk while they still get to reap the rewards.

How do they do this? Debt.

But not by taking on debt themselves. They do it by talking YOU into taking it on instead.



Because as we’ve demonstrated, when a homeowner takes on a mortgage to buy a house and that house goes up, all the fees, commissions, and interest payments the homeowner must pay to cash in on their investment eats up most of the price gains (up to 95%, in the example scenario we discussed in a previous article). In fact, the bank came away with one of the biggest slices of the pie (25%, second only to the slimy real estate agent who got even more). The homeowner was left with only 5% of the gain.

So when the homeowner wins, the bank wins. But what if the homeowner loses? What if the house doesn’t increase in value, stays flat, or even declines? Well, the bank certainly doesn’t lose money. The homeowner may take a haircut on the value of their home, but that value comes right out of their equity. The debt remains, and the homeowner has to keep paying their mortgage payments even if the value of their home is LESS than the value of the mortgage! And if they stop paying? They lose everything when the bank forecloses on their house. Whoever owns the debt always wins.

Now many people have written to us already with some form of debt, asking whether their situation is OK or not. In a perfect world, nobody would owe any debt, because as soon as you owe someone money, you are naturally their bitch and have to do what they tell you. But the world isn’t perfect, obviously. And besides, many people have debt from years ago before they ever came across this blog, so we can’t exactly yell at people for something they did years in the past. So to answer the question of “how much debt is OK?” we use a general rule to calculate that number.

First, take your monthly take-home after-tax pay. Then, subtract off your monthly living expenses (pick a typical month without any one-time spikes like car repairs or whatnot). Multiply by 12. This is your ammo box.

You feeling lucky...PUNK? Photo by Douglas Muth @ Wikipedia
You feeling lucky…PUNK? Photo by Douglas Muth @ Wikipedia

Why do I call it your ammo box? Because this is the amount available to you each and every year you may use to murder the fuck out of some debt. So for example, if you’re a couple and together you make $100,000 after tax, and you spend $50,000 a year on living expenses, then your ammo box is $50,000 a year. That’s how many bullets you have to shoot at your debt.

So how much debt does this translate to? Well, it kinda depends. Specifically, it depends on each debt’s interest rate. Remember those old arcade games where you and a bunch of your friends would beat up an end boss? He’d fall down, everyone would cheer, but then the boss would just flash and re-appear twice as big and four times as angry. A debt’s interest rate is kinda like that. The higher a debt’s interest rate, the faster it grows as you’re trying to shoot it. So the higher the interest rate, the more dangerous it is.

So to measure how dangerous a debt is, we simply calculate how long it will take you to kill it. If a debt grows really fast because it has a high interest rate, we want to be able to kill that thing immediately because if it starts to grow, it’ll very quickly become a snowball that will crush you. If a debt’s interest rate is more manageable, we can take on more of it because it’s not as dangerous.

Generally, the maximum amount of any debt we recommend for anyone is 5 years worth. That means whatever your yearly debt-killing ammo amount, multiplied by 5. Why 5? Because that’s the typical length of a mortgage term. Also, it’s the amount of time we Millennials stay in (or get laid off from) the same job, on average. Our Boomer parents had the luxury of getting a job and counting on it to pay them for decades, but those days are long gone. So any debt that takes more than 5 years to kill is idiotic and dangerous, since our jobs don’t last that long.

But back to the types of debt. What types are debt are there and how much of each is safe to hold?

Consumer Debt

Consumer debt is credit card debt, lines-of-credit, payday loans, that sort of thing. Anything with an interest rate > 10%. This debt is, no surprise here, bad Bad BAD! An acceptable level of consumer debt is 0. Yes, ZERO. Anything above that should be treated as a financial emergency, because it is. It is impossible to build any wealth with consumer debt hanging over your head. Every bullet you have and every bullet you can spare should go into killing this as quickly as possible. Murder with extreme prejudice.

Student Loans

Student loans are a little better, since they don’t accrue interest while you’re in school and Student Loan interest rates generally aren’t as bad since they’re backstopped by the federal government. The current student loan in the USA for undergraduate degrees is around 5% – 7%. At that rate, a reasonable amount of time spent killing this debt is 3 years. Any more and you run the risk of running out of job before running out of debt.


I have some fairly harsh opinions about mortgages, but as far as loans go, mortgages are generally the lowest interest rate debt you can get since it’s secured against the value of your house. Current mortgage rates for a 5-year fixed term as of 2016 are around 2-3%. This debt is fairly safe since the interest rate is fixed for the 5-year term, but once that term is up it will renew at whatever the prevailing interest rates are, and not you, me, or even Fed Chief Janet Yellen can accurately predict where interest rates will be in 5 years. So at maximum you should plan on killing this debt within 5 years.

But but but…

And I know. I know. Killing your mortgage in 5 years is not what the banks tell you to do. You’re supposed to pay that thing off in 25 years, not 5. And the reason they’re telling you that is because they’re trying to hand you enough rope to hang yourself with. They know that your job won’t last 25 years, and they don’t care. They want you to buy more house than you can afford so you can run into trouble later, default, and then they can take your money, plus your house! It’s win-freaking-win! Except, you know, for you.

The reason why we came up with these numbers is because, and we know you might be surprised when we say this, but we don’t trust our jobs to be stable, and we sure as HELL don’t trust the goddamned banks. 5 years of debt slavery under a single mortgage term where they can’t arbitrarily change the interest rate on you is about as much risk we would ever be willing to take, and 5 years of staying in a single job is as much stability that us Millennials can ever count on.

So for our example couple who has an ammo box of $50,000, their maximum safe mortgage amount is $250,000. So take a minute and calculate your own personal safe debt level, and if you’re below these limits, great. You have the Millennial Revolution’s stamp of approval on your debt levels. But if you’re at or above these limits, you are officially over-leveraged.

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28 thoughts on “How Much Debt is Too Much?”

  1. Credit cards should only be used to collect points and repay them at the end of each month. Anything else is a financial suicide. I totally agree with your zero recommendation.

    Another good option regarding mortgage could be to invest those bullets over those 5 years. It’s not impossible at all to have over 2-3% profit per year. Then around the end of the 5 years you see what the new terms are. If much worse, you can shoot this canon ball on it (instead of the bullets each month). If it’s better or roughly the same, then be happy!

    By the way don’t you guys have the option to fix the mortgage rate for 10 years? Here it’s only 0.1% higher than the 5 years fixed one, so I didn’t think too much about which should I choose.

    1. We have 10 year fixed terms, but it’s 1.5 points higher than the 5 year. I’d be more worried about relying on a job being there in 10 years, rather than the interest rate.

  2. Really like this concept of the ammo box. And very good point on paying off those student loans debts FAST. I went into my big law job with the same mentality. Didn’t want to risk running out of a job before my loans were paid off, so I took that ammo box and went to town on that student loan debt. 2.5 years later, all cleaned up. And the job ran out (I let it run out by switching jobs), but without the loans, I could afford to find a different job.

  3. We used to be as anti-debt as you are, and paid off our mortgage in just 3 years.

    Unfortunately, we then came to understand the concept of opportunity costs.

    We’ve since taken out a mortgage again, and are investing the funds. Generally speaking, for the average person, yeah, debt of almost any kind is potentially very bad.

    For the average reader of a personal finance blog, it can be a tool for arbitrage. Simply put, paying off a 30 year mortgage that’s sitting around 3.5% has huge opportunity costs, if you’re disciplined enough to invest the funds instead.

    1. The thing we hate about leverage is that it’s a win-win situation….for the banks. If you take a HELOC out on the house and invest it, how do you hedge against call risk?

      Very impressed that you paid off your mortgage in just 3 years! Nice work!

      1. “The thing we hate about leverage is that it’s a win-win situation….for the banks.”

        But we know that isn’t true, thanks to the recent mortgage crisis here in the US (and banks might re-learn that lesson in the upcoming crash in Canada).

        Lending out money with a house as collateral is not always a”win win” for the banks, because the house can someday be worth less than what’s owed (looking at you, Vancouver), and owners might decide to just walk away from the house rather than making crazy payments they’ll never see back in equity. Sure, the bank can repossess the asset…a lot of good that does you when it’s toxic. Lots of banks took very real losses from that “win win” about a decade ago…a few of those banks went under.

        Point is, there’s certainly risk for all players involved: lenders included. Anyone can lose.

        “If you take a HELOC out on the house and invest it, how do you hedge against call risk?”

        To be clear, we took out a cash-out refi on a paid off home, not a HELOC. It’s a new, 30 year fixed rate mortgage. (Which I understand is not the norm north of the border, where rates adjust, right?)

        Additionally, at least here in the US, banks don’t typically have the ability to call residential loans (unless the loan is a demand note, which would be pretty darn rare). But to answer your question, if we had our note called, we’d sell the investment we’d made with the funds. If the investment had declined, we’d have to tap other funds. (And a second lesson is probably not to arbitrage yourself to the gills. 🙂

        We’ve done the “pay off debt like your hair is on fire” plan. It’s not a bad strategy at all — it’s just not optimal. Savvy folks (i.e. – people who are reading personal finance blogs, and who actually save & invest) would, more often than not, do better taking that extra $1000 they were going to apply to principle, and investing it. They are doing themselves no favors by paying down fixed rate mortgages at historically low rates in the middle of a bull market.

        But just my $0.02. I’ve gone down both paths before and it’s really just comparing a good plan to a somewhat better one. Neither’s going to hurt your situation.

        1. Wait, didn’t those banks get bailed out by the federal government? So they STILL won even when all their mortgages defaulted!

          But anyway, we don’t have no-recourse loans up here in the Frozen North. If you default, the bank can sue you for losses. We also don’t have those crazy adjustable rate mortgages in which the monthly payment can double if interest rates rise. Instead, if interest rates rise, our mortgages keep the monthly payment the same, but increase the amount that goes towards interest. In all likelihood, a catastrophic housing failure here in Canada won’t look like rows and rows of foreclosure signs. Rather, it will be a generation of people being bled dry by their jumbo mortgage on their underwater property that will never ever have money.

          And what you said about savvy folks taking on debt and investing instead I actually agree with. People (like you) who understand the exact terms of their loan, call risk, amortization schedules, etc. and how all that affects their investments can use debt effectively to make money. These people, however, are few and far between. Way too often people just think “I’m using debt to make money in housing” when they TOTALLY aren’t, and they get screwed without realizing it.

        2. Ah, but here in Canada we have this thing called the Canadian Mortgage and Housing Corporation. Yes, the banks will lose when they wind up repossessing all those underwater assets post housing crash, but so will all Canadians who are indirectly on the hook for all those CMHC-backed loans.

          Take it down a layer…it’s not so much ‘the banks’ who are in a win-win…it’s the executives of said banks who are making decisions influenced mightily by bonuses and stock markets that regularly demand ‘better than expected’ quarterly earnings.

  4. Nice enlightening article. The other big hidden “scam” that banks use pertaining to fixed rate mortgages is the way they calculate early termination penalty. In reality, breaking a mortgage contract early occurs very frequently because how many folks sell their house exactly on the day a mortgage is due to expire? Then the banks agree to waive such a fee but only if you buy a new house and set up a brand new mortgage with them again!

    The robbery occurs with layman’s wording of the early break penalty being the higher of 3 months mortgage payments or calculation of the interest rate differential (the discount rate you negotiated relative to the posted rate). So most folks casually think 3 monthly mortgage payments at $2000 per month might result in say $6000 early termination penalty, but will be shocked to really discover the actual penalty using the convoluted interest rate differential calculation amounts to a much higher value in the $15,000 – $20,000 range!

    You could probably write an informative article warning your readers about this scam, but you need to view the fine print in the back of the mortgage footnotes.

    My advice is to start with a variable rate mortgage for the flexibility and uncertainty, because everyone’s life situation can change quickly and you might need to sell or move. You still pay an unjustified 3 months penalty but at least the amount is more concrete.

    1. “breaking a mortgage contract early occurs very frequently because how many folks sell their house exactly on the day a mortgage is due to expire?”

      Very good point! Love how you brought up the early termination penalty…definitely a good subject to write about in a future post. Thanks!

  5. Apparently, USA-based student loans are no longer dischargable in bankruptcy, unlike credit card debt. Given the huge debt levels of some students, it’s not impossible for their own kids to wind up having to make their loan payments after they’re gone…
    In some cases, debt could be “good” if used to buy an asset that makes enough cash to cover the costs of acquiring it, including debt payments…for example, borrowing to buy a business, an apartment building, etc.

    1. FYI in the United States if you die and have student loan debt it would not carry on with you same as any other debt in the US. Basically what happens is that anything that is left of your estate would first go to debts then if anything is left it goes to whoever you leave it to. If you have more debt than assets then it gets forgiven.

    1. Depends on the interest rate. A quick search revealed prevailing average rates of 7-13%, so I’d put it closer to the “consumer” debt side of things. In other words, as close to 0 as possible.

  6. Any debt is bad. In business school they used to teach us, how borrowing money for business is good and indeed in some (rare) cases financing with debt is “ok”, but outside of that all debt is just bad. Debt=Slavery

  7. Just found your blog a couple weeks ago and I have been going through your posts. I really like what I’m seeing here and I’m adding you to my favorites with MMM, JLCollins, and Go Curry Cracker. I was curious about your opinion regarding buying a house if your plan is to be mortgage free/rent free in retirement? I agree completely that it is usually cheaper to rent in about 98% of cities in the US. However, I purchased a fixer upper for pennies on the dollar and have put some good old fashion sweat equity into it. Ultimately my goal is to pay off the mortgage when I retire (about 7 more years at 45 yo). If I decide to move at that point I will sell it myself and use the money from that to purchase another house cash. This way I can live where I want and not have to pay a mortgage or rent. Have you guys looked into the benefits of this plan or is there something that I am missing that will torpedo my retirement boat. Keep up the good work.

    1. Wow! That’s high praise to be put on a list with MMM, JLCollins and GCC. Thanks!

      As for the house purchase, it depends on the math. You’d have to calculate ownership costs and compare that option with renting and investing. Since I don’t know the home prices and rental prices in your area, I can’t really comment on that.

      Crunch the numbers and see if it makes sense.

  8. Great Post!! I love the way you write!

    I don’t have a credit card or a house, so I can’t give much comment on that. But I remember an interesting conversation I had once with my dad about how even student debt is bad. I mean, is college really worth it? Unfortunately, we live in a society were one needs a degree (and, apparently, an ‘entry’ level job also mean 5-7 years of work experience. Cause that makes sense). I have SO MANY FRIENDS who are drowning in student debt, and for what? So they could sit in a room for 4 years and have a human speak at them? People with student debt are trapped before they even have a chance…

    1. Hey Jessica! Welcome to the blog 🙂

      Agree with you that student debt is a HUGE burden on us Millennials. Especially since job security isn’t what it used to be and college degrees aren’t as valuable anymore.

  9. Good one. Any debt is terrible in my view. That’s why I am trying to buy my first home – which will be my future retirement home – by cash outright! I hope to remain debt free for forever. There is something that feels toxic about debt that I am unable to even tolerate, even if a sensible mortgage is “good debt” as my banker friend tells me. Blame it on the Asian culture, eh?

  10. Good stuff…I try to pay everything with cash and when I charge stuff, I pay it off the same month. Usually I charge to get credit card points on big items but save anyway before I buy. I think one problem is that it is so easy for so many people to acquire debt and so tempting too. When I get offers in the mail or email, I rip the envelope or delete the email with only reading the subject line.

    1. Can’t argue with you there. Banks love shoving debt in people’s faces. Back when we were trying to buy a house in 2012, they kept trying to convince use to take out a way bigger mortgage than we needed. They were also constantly giving us offers for credit cards or a personal line of credit. They more credit you take on, the more money they make.

      Paying with cash is a definitely the way to go. Paying with cash makes you FEEL the pain of spending the money. Credit cards don’t. The only time I recommend credit cards is for frequent flyer miles points, which you should cancel immediately after you get the sign-on bonus. For people who have a problem with spending, they should avoid credit cards AT ALL COSTS.

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