How much debt is OK? This is a key question in managing your finances, and while everyone’s circumstances are different, there are thresholds it’s dangerous to exceed.
JP Morgan have come up with a ‘Debt Obesity Scale’, which is like the body mass index - it tells you when you’re hitting danger levels. Before the body mass index came into general use, we could all be a bit blasé if we were a bit overweight, but now that you’re in danger of being judged ‘clinically obese’ if you’re heavier than you should be for your height, you’re probably more inclined to take it seriously.
So the Debt Obesity Scale is a useful reality check. It’s designed to indicate how easily you can pay off your debts - and that doesn’t mean just pay the interest, it means paying debts off completely. It compares the amount of secured and unsecured debts with your income and gives you one of five Debt Obesity ratings - OK, moderate, high, severe and chronic.
Debt obesity too high
The thresholds for ‘OK’ are not that high - your mortgage needs to be less than three times your income and your other debts need to be less than 40% of your income for you to get an all clear.
But there are plenty of people who fall into the moderate or severe categories. For example, John’s income is £30,000. He has a mortgage of £120,000, a personal car loan of £7,000 and credit card debts of £9,000. So he gets a moderate rating on the Debt Obesity Scale.
The ‘affordability’ criteria used by mortgage lenders until recently have resulted in many first time buyers from 2004 to 2007 having mortgages of well above three times their income.
Lender reduce multiples of income
Though lenders could justify this in terms of the proportion of income that was theoretically used to service debts, they must have known that many people concealed the true extent of their other unsecured lending simply to obtain the mortgage they needed to buy the house they wanted. The fact that most lenders have reduced the multiples of income they will lend suggests that they now realise they were allowing people to take on more debt than they could really manage.
If you get a Debt Obesity rating of high, severe or chronic then you need to take immediate action to deal with it. The first thing to do is cut spending in every way you can - a theme we’ll be pursuing in a series of articles in coming weeks. Equally important is prioritising debt and paying off the most expensive debts as fast as you can.
People tend to avoid facing their debt issues, but the longer you leave it, the tougher the problem will get. And once you take the first steps, it’s surprising how quickly you can convert your debt mountain into a molehill, because every pound you pay off the debt saves you so much in interest that you can also use to pay off more of the debt. Maybe a better image is melting a big snowball in the sunshine - it takes a while to melt the outer layer but each layer after that melts faster until you can actually see it vanishing.
Follow our series of articles each week on ways of reducing spending and tips on debt management.
