Borrowing money can be a big decision. Some large purchases like buying a home, a vehicle, or continuing your education may not be possible without taking on debt. Other types of borrowing may be for smaller items, like the items you purchase using a credit card or borrowing money with buy now pay later options. While these purchases may not seem as big, the cost to you can grow when you account for interest and fees that are charged for the service of borrowing.

According to the Federal Reserve of New York, Total household debt rose to a record high in the fourth quarter of 2023 with credit card balances increasing by $50 billion to $1.13 trillion and mortgage balances increasing by $112 billion to $12.25 trillion. In addition, auto loan balances rose by $12 billion to $1.6 trillion and delinquency rates increased for all debt types other than student loans. The recent report shows a bleak outlook with regard to household debt in the U.S.

Understanding loans and APR

When borrowing money, there are typically interest and fees charged with the loan. The amount you end up paying, including interest and fees will likely be higher than the purchase price. When making purchases with a loan (including credit card or buy now pay later services), consider how much you will be paying for the item including borrowing costs before making the purchase. When you decide to take out a loan, compare the annual percentage rate (APR) to see which loan will cost you more in total when comparing different lenders as this rate includes the costs associated with the loan.

Debt to income ratio (DTI)

The debt-to-income ratio (DTI) is a calculation that may be used by lenders to help determine a borrower's ability to pay back a loan. While the exact calculation may vary by lender, the basis of the DTI is to take monthly outstanding debts and divide them by monthly gross income.  The DTI just gives an objective basis for deciding the affordability of a loan and is something you may want to think about if you are considering taking out a loan. According to the Consumer Financial Protection Bureau (CFPB), homeowners may want maintain a DTI of 36% or less and renters may want to maintain a DTI of 15-20% or less.

Effects of borrowing on financial wellness

As borrowing can negatively affect financial wellness, realizing you may have borrowed more than you can handle is an important step to address the concern. Some signs that you may have too much debt according to the CFPB:

• You don’t know how much you owe.
• You spend more money than you make.
• You struggle to make the minimum payments on your debt.
• You miss some required payments. 
• You can’t buy things you need. 
• You don’t have a good borrowing reputation with lenders. 
• You’re not able to save money.

When deciding to take on debt, think about your overall financial goals. For some larger purchases, borrowing money may be the only way to achieve the goal and can work within a financial plan. The key is to have a plan with an understanding of how much you can manage and how you plan to pay back borrowed money. Understanding APRs and how they affect the total cost of a loan can help in comparing borrowing costs. Some tools like DTI calculators can help with making a decision that keeps your ability to pay within reason based on your income and current debts.

For some smaller purchases, taking the total cost (including interest and fees) into consideration may have you reconsidering the purchase. Think about your financial goals before making purchases that may keep you from reaching your overall goals or extend the time to reach your goals. If you are realizing you may have too much debt already, take time to organize your debt and strategize a repayment method that works for you as discussed in a previous blog post on debt.

References

Household debt and credit report. (2024). Household Debt and Credit Report - FEDERAL RESERVE BANK of NEW YORK.

Mahlandt, J. (2023). Do you find debt distressing? University of Illinois Extension: Finding Financial Balance blog.

Mahlandt, J. (2023). Let’s find your financial balance. University of Illinois Extension: Finding Financial Balance blog.

What is a debt-to-income ratio?. (n.d.). Consumer Financial Protection Bureau.