Now there is plenty of information on good debt, bad debt and delinquency rates, but how does it apply to you? How much is too much? When do you know if you’re in over your head? We can take a page from how businesses report their debt and look at your debt to income ratio. Basically, you want to compare your debt obligations to your monthly income.
First calculate your household debt. The Federal Reserve’s Survey of Consumer Finances breaks down debt into six categories: residential debt, vehicle loans, student loan debt, installment debt, credit card debt and other debt. Let’s say your monthly mortgage or rent payment is $890. You pay $375 a month on car loans, $325 a month on student loans and $400 in credit card debt. Your total monthly debt obligations total $1,990. Next, look at your gross monthly income before taxes and pre-tax deductions. For this example, assume your household income is about $6,800 a month.
Your debt to income ratio equals your total monthly loan payments / monthly gross income, or in the case of our example, $1,990/$6,800 = 29.3 percent. This means about 29 percent of your income is dedicated to servicing your debt. Keep in mind, this does not consider your minimum household operating costs of utilities and food.
Most financial advisers recommend that your household debt not exceed 35 percent of your income. So far this household is in pretty good shape with their debt. But that is only half the story. There is also a debt safety ratio, which compares your monthly consumer debt to your monthly net income.
Your debt safety ratio uses your monthly consumer debt, which is your household debt, less your mortgage obligation. In the example above, your consumer debt would be $1,100. Let’s say net pay after taxes is $5,100. Your debt safety ratio = monthly consumer credit payments / monthly take-home pay, or $1,100/$5,100 = 21.6 percent. Most financial experts will recommend that your debt safety ratio should be between 20 percent and 15 percent, but preferably closer to 15 percent. In this example, your household consumer debt is above the recommended debt level.
While this household may be comfortably paying bills, this household could very easily get in trouble if they acquired any more consumer debt. It is important to calculate both these debt ratios to prevent taking on more debt than you can afford.
William G. Lako Jr., CFP, is an executive in residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Lako is a certified financial planner.The MDJ will periodically publish columns from KSU business faculty.