How big a mortgage can you take? How much credit card debt can you carry?
Much has been made about good debt versus bad debt. Getting a mortgage for your home is “good” while an “auto loan” is bad because your auto purchase will depreciate. But how much debt can you afford. Below are some guidelines that in my opinion, you should consider.
Stability of income
How stable is your income? This is a very important factor. The more stable your income, the higher debt load you can sustain. Doctors, for example, can afford to have a bigger mortgage than most of us. It is not just because they have high income, but also because they have higher income potential that is more stable. Most new doctors who graduate have a ton of student loans. Yet banks are slightly more lenient on them simply because they have high and yet stable income growth ahead of them. Many doctors have high student loan debt, a mortgage and very little cash and investable assets in the beginning of their careers.
However, if you are an insurance agent or real estate agent, then your income inherently is less stable (though lucrative). Your ideal debt ratio will depend on your income and assets.
Alternative source of income
Do you have alternative sources of income? Do you have a rental property producing positive cash flow? How much dividends are your investable assets giving you? The more sources of cash inflow you have, the better your ability to take on debt.
What is Your Coverage Ratio?
When bond investors invest in bonds, one of the key ratios they look at is the company’s coverage ratio. What is the the cash flow versus interest payments? For triple A bonds, it is not uncommon to find coverage ratios of 10. For junk bonds, coverage ratios of 1.2 to 1.5 are not uncommon.
What is your coverage ratio? How much income are you bringing in? What is your interest payment every month. To be even more conservative, subtract all necessary household expenses from your income and use that number to calculate your coverage ratio. Ask yourself what your coverage ratio will be if you take on a loan, credit card debt, or a mortgage? If you coverage ratio will barely be one, then you should reconsider whether or not to take than loan or mortgage. If your coverage ratio is above 3 and you have a stable income, then you will be a lot safer.
What is your Debt to Equity or Asset Ratio?
How much debt you can take is also influenced by what is your net worth. If you have a few properties free and clear, taking on another mortgage may not be an issue even if your income source is not stable. Before you take on another debt, be sure to calculate your net worth, both equity and assets, accurately.
How much cash on hand do you have?
Ford and General Motors are in big trouble for their North American Operations. But has kept them going is that they have tons of cash on their balance sheet.
How large is your emergency fund? How long can you last if your present source dries up? Think long and hard about this when before you take on any new debt.
To sum up, I think you have to look at a variety of factors before you can decide how much debt you can take – whether it is a mortgage, auto loan or home improvement loan. Look through these factors carefully before making any big decision that will impact your financial future.