Credit cards are practical and make life easy. You can pay for groceries, holidays, and shopping with your credit card while also paying off the credit balance at the end of each month. But what happens if you can’t afford to pay the balance in full? What happens if you only pay the minimum payment and the credit card balance starts ballooning? Are you in too much credit card debt?
The threshold of "too much debt" isn't a one-size-fits-all figure but rather a subjective measure. This metric is influenced by your personal finance, income level, spending habits, and long-term financial goals. Most banks, credit bureaus, and creditors have established debt management program guidelines to help their customers assess whether they are in too much credit card debt.
Let’s take a look at how much credit card debt is considered too much and how you can lower your credit utilization rate to more manageable levels as quickly as possible.
Debt-to-Income Ratio
The debt-to-income (DTI) ratio is a fundamental metric in personal finance. It helps individuals assess their ability to manage debt repayments and any late payments in relation to their income.
To calculate your DTI, divide your total monthly debt payments by your gross monthly income and multiply by 100 to get a percentage. For instance, if your monthly debts (including mortgage, car payments, and credit card payments) total $1,500 and your gross monthly income is $5,000, your DTI ratio is 30%.
The reason why DTI is important is because your creditors want to know whether you can afford to pay for other expenses after repaying your debt. You must, for example, be able to pay for groceries, everyday expenses, gas, and utilities.
A DTI ratio of 36% or lower is generally considered manageable because it leaves enough financial room to make a good management plan and pay for your living expenses. However, when it comes to a credit debt management plan, you should try to keep it under 10%. If your credit card debt alone exceeds this threshold, it may signal that you're over-leveraged and at risk of financial strain.
Credit Utilization Ratio
The credit utilization ratio is calculated by dividing your total credit card balances by your total credit card limits and is expressed as a percentage. This metric is used for credit scoring models, as it can significantly impact your credit score.
How to Calculate Credit Utilization Rate
To calculate your credit utilization rate, follow these steps:
Add Up Your Balances: Determine the current balance on each of your credit cards. For example, if you have three credit cards with balances of $500, $1,000, and $1,500, the total balance would be $3,000.
Add Up Your Credit Limits: Add the credit limits of all your credit cards. For instance, if the credit limits on your three cards are $2,000, $4,000, and $6,000, the total credit limit would be $12,000.
Divide Balances by Limits: Divide your total balance by your total credit limit to get the utilization rate. Multiply by 100 to get a percentage.
In the above example, 3000/12000 = 0.25.
0.25 x 100= 25%
In this example, your credit utilization rate is 25%.
Why is Credit Utilization Important?
Lenders perceive a high credit card utilization rate as a sign of higher credit risk. If you are using a large portion of your available credit, it may indicate financial distress or a higher likelihood of default. Remember that credit cards are a type of debt; the more you use your credit card, the more indebted you get.
Also, you can positively affect your credit score when you maintain a lower utilization rate. Conversely, a high utilization rate can negatively impact your score, even if you make all your payments on time.
Finally, a lower utilization rate can make you more attractive to lenders and improve your chances of being approved for new credit lines or personal loans with favorable terms.
Optimal Utilization Rate
Financial experts recommend keeping your credit utilization rate below 30% to maintain a healthy credit score. In the above example, 25% is a reasonable amount of credit card debt.
However, the lower, the better. Those with the highest credit scores often have utilization rates below 10%. Here’s a breakdown of what different utilization rates might mean:
- 0-10%: Excellent. This means that you are using very little of your available credit and managing your debt well.
- 11-30%: Good. This range is generally considered acceptable and shows that you are using your credit responsibly.
- 31-50%: Fair. You may start to see a negative impact on your credit score if you consistently maintain a utilization rate in this range.
- 51% and above: Poor. Such high utilization rates can significantly damage your credit score and signal to lenders that you may be overextended financially.
Credit Card and Personal Financial Situation
We have talked about what credit agencies and creditors consider acceptable when it comes to credit debt levels. However, many factors can affect whether your average credit card debt is too high.
For example, if you want to buy your first home, you want to have as little credit card debt as possible to land a good interest rate and favorable terms on your mortgage. In this case, you need to aim for the lowest credit card utilization rate possible.
If you are switching jobs and may be spending some time looking for a new job, you need the wiggle room available on your credit card to pay for necessities. In this case, again, you want to have a low credit utilization rate so you can keep going until you find a new job.
Conversely, you can afford a higher credit utilization rate if a new family member is about to enter the job market and will be bringing extra income to the household. With the extra income, you have found a way to pay back your credit card debt beyond the minimum payment and lower the balance.
Finally, reflect on your long-term financial goals. Whether it's buying a home, starting a business, or saving for retirement, excessive credit card debt can be a significant obstacle. If you find that debt repayments are delaying your ability to achieve these goals, it's time to take action. Prioritize debt reduction to reach your financial goals and meet your financial expectations.
How To Pay Off Credit Card Debt
Create a Budget
Track your income and expenses. A clear budget helps you identify areas where you can cut back and allocate more money to pay your debt.
Prioritize Debt Payments
Focus on paying off high-interest debt first, often referred to as the avalanche method. Alternatively, the snowball method involves paying off smaller lower balances first for a psychological boost. Choose whichever method works best for you and helps you achieve your goal.
Negotiate with Creditors
Contact your credit card company to negotiate lower interest rates or a payment plan. Many creditors are willing to work with you and offer financial advice if you communicate proactively and show them a realistic repayment plan.
Consolidate Debt
Consider a balance transfer credit card with a lower credit card interest rate or a personal debt consolidation loan to consolidate multiple high-interest rate debts into one manageable payment.
Increase Income
Look for ways to boost your income, such as freelance work, part-time jobs, or selling unused items. Additional income can go towards your debt repayment process.
Cut Unnecessary Expenses
Review your spending habits, travel credit cards, and overall credit history, and cut out non-essential expenses. Redirect these funds towards paying down your debt. We know it’s hard to resist a holiday weekend or a shopping spree, but your credit score will thank you for it.
Seek Professional Help
If you're overwhelmed, work with a credit counselor or a credit counseling agency. They can provide personalized strategies and support.
Build an Emergency Fund
While paying off debt, try to save towards a small emergency fund to avoid accruing more debt in case of unexpected expenses. Emergencies like a car breakdown can be covered by such emergency funds.
Manage Your Credit Card Debt
Credit cards remain one of the greatest conveniences of modern times. However, you should find the best money market accounts, monitor your credit card utilization rate, and keep your debt at manageable levels.
What does ‘manageable levels’ mean? It means you can easily sustain your credit card debt and repay it. If you feel that your credit card balances are getting out of hand, then you could work towards limiting your expenses and repaying your debt.
If you feel you need help with this, contact a debt specialist like ClearOne. Our certified debt specialists will analyze your finances and find the best solution for your credit card debt. We are trusted, reputable, and professional and have the know-how to help you gain financial freedom!
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