How much debt is safe?

Wednesday 22 October 2014, 3:45PM
By Harold French

Headlines warning that Kiwis are making no attempt to pay off their mortgages and that pensioners are struggling with debt raise the question of whether it is best to learn to live with debt – and how much of it is safe – rather than telling people how to avoid it.

The media is full of experts telling us not to get into debt, that debt is bad and that we should get rid of it quicker than juggling a hot potato, but the reality is that it is hard to live without debt.

For example, many hotels, most car hire companies and other conveniences of modern day life require things like credit cards before they will do business with you.

It is, however, important to remember that a responsibly managed credit facility does not necessarily constitute debt. For example, if you pay your credit card off every month, it is not a debt.

There are also times when debt can be used to achieve long-term savings. For example, buying when there’s a sale and when the terms are interest free for a set period. Unlike a credit card facility, this last example is debt, but, provided you pay off the interest free debt within the required time, it is not likely to be onerous.

Careful use and management of credit and debt can enhance your life in many ways, but how much debt is it safe to incur? The short answer is ‘as little as possible’ or ‘not more than you can handle’ but if you’re looking for the debt limit, the absolute roof, then you might find it around 30 per cent of your gross income.

New Zealand Treasury authors of the report ‘Household Debt in New Zealand’, Katherine Henderson and Grant M. Scobie, suggest that people with debt exceeding 30 per cent of their gross income may be vulnerable.

But, of course, conditions apply.

“Those at risk were defined as having debt servicing obligations exceeding 30 per cent of their gross income and, at the same time, recording negative net wealth.”

Negative net wealth applies to a situation in which a person has more liabilities than assets. So if you have more debt than you do assets, and that debt exceeds 30 per cent of your gross income, it may be a good idea to consider getting expert advice and taking action to restore yourself to a healthier financial position.

Whether that is approach a lender such as GE Money for a debt consolidation loan, seeking expert financial advice for the likes of Spicers or speaking to a budget service such as CAP Money, will depend on your own circumstances and your risk profile.

A debt consolidation loan will give you better control of your finances by rolling your debts into one fixed repayment each month – there’s no need to pay multiple lenders and no risk of incurring multiple fees and late payment penalties – but it is important to make sure that you end up paying the same, or less, in interest.

In every instance it is important to understand your financial position in terms of your gross income, liabilities and assets. Here are some tools you can use to get a handle on your financial situation:

1. Debt-to-income ratio (DTI)
2. Debt-to-asset ratios (DTA)
3. Net worth

Debt-to-income ratio (DTI)

Your debt-to-income ratio measures your monthly gross income against the debt payments you have to make each month. It is the simplest ratio and one used by some lenders to determine if you can make your monthly payments.

It is possible that lenders will measure your debt-to-income ratio using two other ratios, your front-end ratio and your back-end ratio.

Front-end ratio refers to asset costs like housing costs, mortgage, insurances, rent and property taxes. Back-end ratio refers to debt that is not necessarily asset based, such as credit cards and hire purchases.

The problem with debt-to-income ratio is that individuals on high incomes can probably afford to have a higher than 30% debt against gross income simply because they have enough money to live, and live well. The rest is disposable.

Debt-to-asset ratio (DTA)

Debt-to-asset ratio is defined as the ratio of total debt to total assets. In other words, can your assets cover the cost of your debt?

Where this ratio falls down a bit however, is if you are borrowing money to study towards a qualification. When you do this, you are in effect investing in an asset, which is yourself. You cannot be sold, but you can sell your skills and that is an asset.

Net worth

Your net worth is determined by adding up everything you own – house, car, savings accounts, and investments – and subtracting the total from your debts. The result is your net worth, or the cash you would have in your hand if you sold everything you own today.

The problem with net worth is that on average younger people have a lower, even negative, net worth than older people because they are by necessity building for the future e.g. high mortgage, study loans etc.

Net worth can be used as a long-term measure with the aim of ensuring your net worth increases as you get older. In other words, the value of your net assets should grow in value while your debts total decreases in value.


Consider applying the debt-to-income ratio to get a snap shot of your financial position. If your debt exceeds 30 per cent of your gross income, it may be prudent to consider consolidating your debt.

Use the net worth ratio to establish your current net worth and set some long term goals, like paying off a property, investing in education or paying down debt to build your net worth up over time.