Debt is a controversial topic in the financial world. Bring it up in certain situations, and the emotions come out.
One camp tells you that debt is evil and you should get it out of your life for good. Another camp says you should use ‘other people’s money’ as often as you can. Even to the point of maxing out your credit cards to finance your business and grow faster or get to that big sale.
Your coworker proudly brags that she’s debt free except for her house. Your neighbor tells you sheepishly that he’s paying $1,900 a month for that old truck, camper, and boat in his driveway while he still has $22,000 in student loans.
Most people can agree on having a home mortgage with a fixed interest rate. We even call it ‘good’ debt sometimes. But how much of a good thing is too much?
I first explored the concept of money and happiness in How Much Money Do You Need for Peak Happiness? The first article focuses on income and net worth as they relate to happiness. If you haven’t read it yet, take a look and then come back here! If you have read it, here’s a reminder of what the two happiness curves looked like:
The income vs. happiness curve assumed that the person’s debt would increase at a slower pace than their income. However, for many people in consumer societies such as America, that isn’t what happens.
The net worth vs. happiness curve only explored debt in the context of negative net worth—where debt is greater than assets. It did not consider the person’s ability to make payments on that debt.
To fully explore money and happiness, then, we need to add debt to the conversion.
Let’s take a closer look at debt and happiness.
1 Debt-to-income ratio matters most
If someone tells you how much debt they have, you won’t have enough information to decide if it’s too much to handle. You’d also need to know the payment terms and how much income they have to make the payments.
Instead of working with the absolute value of debt, then, we’ll use debt-to-income ratio.
1.1 What is debt-to-income ratio?
Debt-to-income ratio is a person’s total monthly debt payments divided by their gross monthly income, expressed as a percentage.
A person who makes $5,000 per month before taxes and has debt payments of $2,000 per month has a debt-to-income ratio of 40% (2,000 ÷ 5,000 × 100% = 40%).
The income vs. happiness curve in Figure 1 shows a steep increase in happiness as income goes from poverty levels to upper-middle class. If debt-to-income ratio is not improving as income goes up, however, then happiness would likely increase slower than shown.
1.2 Same income, different stories
To illustrate the importance of keeping debt-to-income ratio low, meet Ryan and Tricia:
Ryan is 23, and just graduated from college with a degree in finance. He got a great job at a hedge fund, and will be making $150k this year if he earns his bonus!
Ryan celebrated the new paycheck the way any self-respecting investment banker would. He signed a lease on a new BMW for $750/month and took a trip to Switzerland with his buddies. He didn’t have the $4,100 for the trip yet, but he’d earn that in no time. So he put it on his credit card.
Then Ryan realized he needed a 3% minimum down payment for a condo. So he made the minimum payments on his credit card, bought a condo downtown, and began making the $3,300 mortgage payments. Of course, now he needed furniture for the condo, which added another $6,000 to his credit card balance.
Then his student loan payments started to kick in. They were just $200/month, but this was adding up fast!
Before he realized it, his entire paycheck was eaten up by payments and essentials like food, gas, and utilities. Ryan was living paycheck-to-paycheck on a six-figure salary!
—
Tricia graduated with a law degree at the same time as Ryan. She went to work at a big firm that would also pay her $150k in the first year if she made her bonus.
Tricia bought a 2-year-old Honda as soon as she had the cash. It wasn’t as flashy as what some of the other new attorneys in her office drove. But it looked new enough and she didn’t care.
Her clients weren’t making their assessment of her in the parking lot. They wanted results in the boardroom and the courtroom. So she focused on how she presented herself professionally, and on the results that she got for them.
Tricia had a nice apartment that she shared with two roommates while she saved for a home. She was also saving for a summer vacation and a trip home for the holidays.
When her student loan payments kicked in, Tricia was able to afford them without trouble. She paid attention to her expenses, and had already made room for student loans.
—
Ryan and Tricia have the same income, but vastly different debt-to-income ratios. Ryan has more stress over making his payments, and isn’t able to save for emergencies or retirement. Any shocks to his income or expenses will create their own ‘emergency’.
Ryan’s baseline happiness is lower than Tricia’s as a result.
1.3 Bank limits on debt-to-income ratio
Banks are in the business of loaning money to people who they believe can pay them back. This makes them highly interested in debt-to-income ratios, and a great place to start in determining how much is too much. So what do the banks have to say about debt-to-income ratios?
According to Bankrate.com, most lenders will allow a total debt-to-income ratio of no more than 45%. Some will go as high as 50%, but require the borrower to have additional savings in that case. These maximums are higher than banks would really like to see, however. Lower is better.
What the banks ideally want is for mortgage debt to be no more than 28% and total debt-to-income to stay below 36%.
This article by Investopedia outlines Wells Fargo’s Debt-To-Income (DTI) guidelines, which agree with the numbers above:
- 35% or less – Your debt is manageable and you’ll likely have money remaining after paying bills.
- 36% to 49% – Your DTI ratio has room for improvement. Consider lowering DTI to be in better position for unforeseen expenses. Lenders might ask for other eligibility requirements.
- 50%+ – You have limited money to save or spend and you won’t likely have money to handle an unforeseen event.
1.4 How much do we usually spend on everything else?
The bank guidelines seem to assign 50-55% of gross pay to taxes and daily expenses. The ideal DTI limit assigns 10-15% for savings and unforeseen expenses, and the hard limits assign 0-5%. Table 1 shows how I got these numbers.
Now we can work backwards by looking at typical taxes and expenses to see if the bank’s numbers make sense.
1.4.1 Taxes
To get a feel for how much of a person’s income goes to taxes, we’ll use data from taxfoundation.org.
According to this article, someone with a household income around $100k pays about 10% in federal taxes. Incomes from $50k-200k would pay roughly 6-14%. Social security and Medicare taxes (aka FICA) are 7.65% up to a limit, so someone with a $200k income will pay closer to 5.5%. State taxes are highly dependent on where you live, but we can call the typical range 3-5%.
There are also property and sales taxes, which vary widely. We’ll leave these out of the discussion for simplicity. They are often higher for low income tax states and vice versa, so we can also consider the 3-5% state tax range to partially include them.
Table 2 summarizes these numbers. From a very high level, we can say that taxes typically fall in the 17-25% range for a majority of Americans. Your situation may be different.
1.4.2 Other daily expenses
We’ll use data from a LendingTree article called Average Household Budget: How Much Does the Typical American Spend to get a feel for how much people typically spend as a percentage of their income.
This article was used to create Table 3, which doesn’t include costs for purchasing a vehicle or home. Those are assumed to be debt payments for our purposes.
As another check on our tax numbers, this report also lists FICA and other taxes as about 19% total for the ‘typical American’ making $84k/year. This falls at the high end of our range in Table 2 for someone making $50k. Close enough for this exercise.
1.4.3 How much money is left for debt payments?
Adding our tax and other expenses data together and presenting it alongside the bank guidelines from Table 1 results in Table 4.
As you can see, our data says that the ‘typical’ American spends 59-67% on taxes and other expenses, which is about 10% more than the banks are assuming.
Look at the red numbers. If the typical American has a debt-to-income ratio of 35%, there’s little or no room for savings and unforeseen expenses. This only gets worse if debt-to-income ratio is in the 45-50% range.
It looks here as if banks are being too aggressive in their guidelines for the typical American. They probably know this, but are taking a calculated risk to try to increase profits. After all, most people will pay their mortgage before worrying about their credit card bill.
2 Studies on debt and happiness
Before we develop the debt vs. happiness curves to go along with Figure 1, we need to look at the conclusions from studies on debt and happiness. What can we learn that might support our own conclusions?
There have been very few studies on debt and happiness. Here’s what I found:
2.1 The psychological cost of debt
A popular investing website called Motley Fool conducted a survey on The Psychological Cost of Debt. The survey included 1,007 people, 362 who had more than $1,000 in debt.
Those with debt reported less satisfaction and fulfillment overall than those who didn’t have debt. Fewer said they “lived life to its fullest” and “made the most of themselves”. Personal loans were the most expensive, but medical debt was the biggest reason that people were unable to make minimum monthly payments.
Medical debt brought the most shame, but 57% were also ashamed of their mortgage.
Credit card debt brought the most guilt. 48% who had debt thought about it daily or almost daily.
The take-away that I get from this survey is not surprising. Debt tends to reduce happiness by causing stress, guilt and shame.
2.2 Debt and subjective well-being
I only found one study, from Purdue, which looked directly at debt and happiness. Its focus was on student loans, however.
This study found that “debt and income accounted for 40 and 60% of the predicted variance of life satisfaction, respectively.” So while income was a stronger predictor of happiness, debt also had a strong relationship.
I would expect the relationship between debt and happiness to be stronger if all forms of debt were included in the study. Not just student loans.
2.3 Household debt and depression
Researchers seem to focus more on debt’s relationship to depression rather than happiness.
This makes sense because debt and happiness are inversely related. Higher debt lowers happiness and vice versa. Debt and depression, on the other hand, are directly related. Higher debt increases cases of depression.
Two studies on debt and depression in adults stood out to me.
The first study was performed in the US. It found that “short-term debt may have an adverse influence on psychological wellbeing, particularly for those who are less educated, approaching retirement age, or unmarried.”
The second study compared 3 European countries with similar social welfare systems to control for the safety nets available to those citizens. It found that “low or substantial financial debt was associated with a higher number of depressive symptoms in all countries. Housing debt was strongly linked to depressive symptoms for women while the association was weaker for men.”
2.4 Conclusions from debt and happiness studies
It isn’t surprising that debt causes more stress, guilt, shame, and symptoms of depression. Nor is it surprising that debt can be linked to a reduction in happiness. The most interesting part of these studies to me was that the type of debt matters, and that women and men may respond differently to different types of debt.
According to these studies, medical debt causes the most shame. Credit card debt causes the most guilt. And women are less happy with mortgage debt than men, in general.
This leads me to believe that mortgage debt, at a minimum, has a different happiness curve than other forms of debt that are not backed by an appreciating asset.
3 The debt vs. happiness curves
We are now prepared to draw the PathwayToFI debt vs. happiness curves, which are presented in Figure 2.
I broke up the curves into mortgage, non-mortgage, and mixed (about 50/50) debt to show that not all debt is equal.
Note that we’re only talking about personal debt, not business debt. Business debt is assumed to be part of income generation and tied to job stress, which was covered in the income vs. happiness curve.
3.1 Mortgage debt and happiness
Mortgage debt allows you to own a home much earlier in life, even if the bank technically owns a larger share than you do. Most people are prideful of their homes, and happy with where they live.
Your home generally increases in value over time. So if you need to get out of the debt you can sell and pay it off in a matter of weeks or months. This is the biggest difference between mortgage and non-mortgage debt.
You can’t sell your degree to pay off student loans or your x-rays to pay off medical bills. But you can sell your home to pay off your mortgage.
These positive factors keep happiness high up to 10%, 15%, maybe even 20% debt-to-income ratios. There is still room in your budget since your mortgage is all the debt you have. You’re able to save, fix a car when it unexpectedly breaks down, and afford a few luxuries.
Life is pretty good in this range.
As debt-to-income reaches 25-30%, your mortgage is starting to dominate your expenses. There is less room to save for the future. Less money to pay for the broken water heater. Less money to go on that dream vacation.
Life could be better.
Beyond 30%, the happiness curve drops fast. Something must have gone wrong with your income. The banks wouldn’t have given you this mortgage if they knew you were going to make less money, not more.
You’re financially stressed, wondering if you can really afford this home. According to the right side of Table 4, you probably aren’t saving much for retirement. You might even be forced to take on more debt if you can’t cut costs somewhere!
You’ll be much happier when you can pick up your income again.
Now, you might be thinking, “You’re wrong Blake. I am perfectly happy with my 10% DTI mortgage. I would never pay it off, and if I did I wouldn’t be any happier.”
I’ve been in both places, and my experience is that owing nothing to anyone is one of the most freeing feelings in the world. When you have zero payments, your income goes so much farther. You might not even need to work for income anymore!
When we paid off our mortgages 5 years ago, big life decisions were much easier!
My wife could easily work part-time because we had such amazing cash flow every month. We were still able to save 50% of our pay!
And I could easily quit my job in 2022 because we didn’t have to worry about pulling money out of the stock market while it was down 20% in order to pay a mortgage.
Life is simpler. Sleep is better. There is peace and abundance when you fully own your home.
3.2 Non-mortgage debt and happiness
Credit card, student, auto, and medical debt are all lumped into non-mortgage debt.
Some may argue that your auto loan is backed by the vehicle, so it shouldn’t be in this category. Plus, the average car loan in the US is a hefty $648, according to this article. I’ve had mortgages lower than that!
But vehicles lose value as soon as you begin driving them. You’ll almost always have to come up with extra money to pay off your loan if you sell your vehicle early. So I decided auto loans didn’t deserve another category.
Happiness drops immediately as non-mortgage debt increases above zero. As the studies above showed, even small amounts of debt can bring guilt, shame, and have you thinking about it constantly.
The inherent assumption here is that someone who only has non-mortgage debt is a renter, not a home owner. Therefore, their non-debt expenses are higher by about 12%, according to the same LendingTree article that we used earlier.
Modifying Table 4 for the expenses of a ‘typical’ American renter gives us Table 5. Three different debt-to-income ratios are used to show how even smaller levels of debt cause renters to run out of money quickly.
This makes it obvious that debt-to-income limits should be much lower if a home mortgage isn’t included in DTI. It also helps to justify the steeper decline in happiness at lower debt levels in Figure 2.
Happiness nearly bottoms out after about 30% of non-mortgage debt. We see from Table 5 that you’re sliding into bankruptcy from here unless you do one of two things: make huge reductions in your lifestyle or increase your income fast!
Beyond 40%, more debt doesn’t matter much anymore. You’re probably feeling hopeless and preparing for bankruptcy unless a big pay increase or windfall is coming.
3.3 Mixed debt and happiness
The third debt vs. happiness curve is for mixed mortgage and non-mortgage debt. This is a middle road between all mortgage debt and all non-mortgage debt, as far as happiness is concerned.
The specific curve drawn in Figure 2 is an example of where happiness would fall at about 50/50 mortgage and non-mortgage debt. In fact, there is a continuum between the mortgage and non-mortgage curves. If most of your debt is a mortgage, you will be closer to the ‘Mortgage Debt’ curve. If most of it is non-mortgage, you’ll be closer to the ‘Non-Mortgage Debt’ curve.
4 Summary
I’ll summarize this article the same way I did my first article on happiness and money:
Happiness has much more to do with relationships, health, and environment than it has to do with money.
Don’t take the happiness curves in this article to mean that you can’t be happy if your debt is high. You absolutely can!
You just need to control what you can. And one thing you have the ability to improve about your life is your financial situation.
Research is inconclusive. However, it confirms that happiness improves as debt is reduced. It has also shown that non-mortgage debt has a stronger affect on happiness than mortgage debt.
This article looked at how banks limit debt-to-income ratios, and how those limits are related to taxes and other daily expenses. This was added to the available research to present the PathwayToFI debt vs. happiness curves.
Through this discussion, three main conclusions were made:
- Happiness peaks when debt is zero
- Happiness declines fastest when debt payments leave no room for saving for the future or paying for unforeseen events
- Low levels of non-mortgage debt have a bigger impact on happiness than low levels of mortgage debt
Do you agree with the research and conclusions? I’d love to hear your thoughts!
Where are you on the happiness curves? Do you have a plan to reach “peak happiness” by this measure?
If you are still at the Trailhead of your financial journey, looking to earn more, get out of debt and begin building wealth, read this article next. If you are already well on your way in your career and wealth-building journey, there is plenty more for you here.
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