How Much Debt is too Much?
Is it possible to have too much of a good thing? When it comes to debt, the answer is yes!
Strike a Good Balance Between Debt and Income
We all recognize that more income is a good thing, and more debt is generally a bad thing. But what’s a healthy balance to maintain between income and debt? Calculating your debt ratios is a simple way to test if you are living beyond your financial means. If your ratios are too high, any loss in income or increase in debt could leave you with more than you can handle.
There are several different debt-to-income (DTI) ratios out there. Financial institutions use these ratios to determine if you’re a good credit risk or not. Commonly used ratios include:
This is calculated by adding up your minimum monthly debt payments (credit cards, auto loan, student loans, etc.) and dividing that sum by your gross (pretax) income. Try to keep your consumer DTI below 20 – 23%.
Calculate your housing DTI by dividing the sum of your monthly housing payment (mortgage or rent, utilities, condo, or association fees) by your monthly gross (pretax) income. Ideally, housing DTI should be below 25 – 28% of gross income.
Add up all your monthly debt payments, including housing and all consumer debt payments, and divide the sum by your monthly gross (pretax) income. Strive to keep this ratio below 43%.
Debt Ratios: Meet Staff Sergeant Smith
SSgt Smith is purchasing a townhome and is trying to figure out his debt-to-income ratios. His gross monthly income is $4,500 and the townhome will cost approximately $1,200 per month. He also has a truck payment of $450, a credit card payment of $100, and a student loan payment of $150. Here are SSgt Smith’s debt ratios:
- Consumer DTI: (450+100+150)/4,500 = 0.155 or 15%
- Housing DTI: 1,200/4,500 = 0.266 or 27%
- Total DTI: (700+1,200)/4,500 = 0.422 or 42%
SSgt Smith is below the threshold for consumer, housing and total DTI ratios. However, he is close to exceeding the recommended total DTI range of 43%. SSgt Smith should consider paying down his debt before borrowing any additional money.