Did you know that if you have no debt and $10 in your pocket, then you are richer than 15% of all American households? It’s shocking but true. America is in debt and not getting out of it any time soon.
What Lies In Your Debt can help you manage your debt and determine the best ways to pay it off quickly. We must learn as individuals and households to control our finances, reduce and pay off loans, and budget in such a way that we aren’t all living thousands or more dollars in debt for our entire lives.
With the American lifestyle and so many different kinds of loans it is almost impossible for the average household not to have some sort of debt. Student loans, mortgages, credit cards, and more are all designed to give us things we can’t afford without having to pay for them up front.
Learning a bit about the different types of debt and the formulas that work for you can help you stay in the green.
Understanding debt can be overwhelming. With so many numbers and buzz words it seems like you need a college course to fully understand your finances. A crucial step to take control of your debt is to know the kinds of debt you have.
Secured debt is a term that means debt that is backed by collateral, meaning the person who lends the money has the right to repossess the borrower’s assets (house, car, etc.) if they have failed to make their payments. Mortgages and auto loans are examples of secured debt.
Unsecured debt, like student loans or debt from credit cards, means the debt is only backed by the borrower’s word.
Secured debt means you are borrowing against what you already have, so in theory, you can always repay the debt. Unsecured debt means you are borrowing against your word without any actual assets or money to back it up.
While secured debt has a better reputation, partly because your collateral assets could increase in value, unsecured debt isn’t necessarily bad. You just need to know how much debt you can afford.
How do you determine the amount of debt that is affordable for you? There is a straightforward formula that can help you calculate whether you have too much debt. The debt-to-income ratio, or DTI, is your monthly debt divided by your gross monthly income. This number will be a percentage, and can tell you whether your debt is within your affordable limits or not.
It is important to distinguish the difference between gross income and net income. Gross income refers to the amount of money you make before any allowances like taxes, health insurance, or retirement are taken out of your paycheck.
Net income refers to the amount of money you have left after all those things are taken out. Make sure you are using your gross income instead of net income when calculating your debt-to-income ratio.
Your monthly debt refers to payments on loans you make every month, such as rent, mortgages, auto loans, student loans, and credit cards bills. Note that this does not apply to your monthly expenses like gas, groceries, or daycare. You only want to use your monthly payments towards loans when calculating your debt-to-income ratio, not all of your monthly expenses.
So what percentage is a good DTI? Truthfully there is no one acceptable number and different financial advisers will tell you different things.
A good rule of thumb is that housing loans (rent or mortgage) should never be more than about a third of your income, and your total DTI should be below 36%.
Many financial advisers suggest keeping it much lower than this, at closer to 28% or even 20%. If your DTI is over 43% you will most likely not be able to qualify for a mortgage loan. Try to keep your DTI below 36%, and preferably as close to 20% as possible.
Let’s see this formula in action:
Say your gross income (remember, this means income before any money is taken out) is $5,000 per month or $60,000 per year.
If your mortgage or rent costs $500 per month, your car payment loan is $200 per month, your student loans are $200 per month, and your credit card payments are $200 per month, then that puts your total monthly loan payments or debt at $1,100.
Plugging this information into the debt-to-income ratio formula looks like this:
1,100 ÷ 5,000 = 0.22, or 22%.
This is a great DTI and puts you well within the affordable range.
Say your gross income is $120,000 per year or $10,000 per month. If your mortgage costs $2,000 per month, your car payment is $700 per month, your student loans are $500 per month, and your credit card payments are $1,000 per month, your formula would look like this:
4,200 ÷ 10,000 = .42 or 42%.
This is higher than the recommended DTI and dangerously close to not being able to get a mortgage loan, and likely already making it very difficult to do so.
As you can see, having a higher income doesn’t necessarily guarantee a better debt-to-income ratio.
While making more money can certainly help pay off debt faster, it is more important to make choices that will keep your loan payments as low as possible.
If your dream car has a $500 monthly payment, but a perfectly good, reliable car has a monthly payment of $200, selecting the lower payment car can reduce your DTI.
You might not be able to immediately increase your income but you can choose the debts you take on.
Use the DTI ratio calculator to help you make the best decisions when selecting loans, and make sure you can afford your debt. What Lies In Your Debt can help you in this process to ensure that you do not end up overwhelmed with debt you can’t afford.