Are you out of your debt comfort zone? Does it seem as though you’re paying too much to bill collectors and not enough for savings and the things you enjoy in life? If so, it’s a good idea to figure out just how much debt you have and compare that to how much you earn. This will give you clear understanding of your financial health.
Debt load is a term that is used to describe a consumer’s amount of debt. It is often used to understand if you are carrying a “safe” amount of debt. Creditors look at a debt/income ratio, comparing your income with your debts to analyze whether you have an appropriate amount of debt. The debt/income ratio is figured monthly and reveals either how good — or bad — your financial situation is.
Debt load is the sum total of all the money you owe:
- Student Loans
- Credit Cards
- Even loans from friends and family.
Once you have your debt load figured out, you’ll want to know just how big of a burden it is. You can figure out this ratio for yourself the way banks and creditors do, by calculating your debt/income ratio – the amount you owe compared to the amount you earn. It’s easy:
- Calculate all your monthly non-housing debt payments – including credit cards and child support. (If you don’t have fixed monthly payments, you can estimate your monthly payments at 4 percent of the total amount you owe.)
- Take your gross annual wages and divide them by 12. That’s your monthly income. If you don’t have fixed monthly payments on revolving debts such as credit cards, you can estimate your monthly payments at 4% of the total amount you owe.
- Take your monthly payments total and divide it by your monthly income.
- It is usually expressed as a percentage, so move the decimal point two places to the right. That’s your debt/income ratio.Example:
Gross monthly income is $2,000
Monthly debt is $500 (credit-card payments, gasoline bills and car payments)
$500÷$2,000 = 0.25
Your debt/income ratio is 25%
How much is too much?
Only you can know for sure how much debt is too much. If you’re feeling a financial squeeze every month because of credit card bills, you don’t need anyone to tell you you’re out of your debt comfort zone – you know.
If your non-housing debt is 10% or less, you’re in great financial fitness. If your non-housing debt is between 10% and 20%, then you’ll probably be able to get credit. But the closer you get to 20%, the closer you get to the edge of a reasonable debt load. Creditors will be less likely to give a loan to someone with such a high debt/income ratio, and those that do will probably charge higher interest.
Worse, if you have a debt/income ratio above 20 %, chances are you’ll feel a strain on your budget.
As for the housing debt that’s been left out of your calculations, there have been many attempts to devise formulae for setting limits on the amount of real-estate debt one should carry. One philosophy recommends the rate of twice to three times your annual income. If the annual household income is $70,000, then, a mortgage grantor might loan up to $210,000, provided the house is worth the money and the other credit factors are satisfactory.
But consumers should receive this information with temperance. Just because a lender may be prepared to extend credit up to a certain ceiling doesn’t mean you should reach for it. You should also factor in your own specific fixed and variable expenses to determine your ability to pay. How much you spend on real estate may depend on what area of the country you live in. And remember: if you clock in high on the real-estate debt, you probably want to compensate with a lower debt/income ratio.
The 28/36 Rule
Another helpful guide is one mortgage lenders use: the “28/36 rule.” This rule suggests that your monthly household debt service not exceed 28% of your gross monthly income. And your total debt service, including your house payments and all other financial obligations, should not exceed 36% of your gross monthly income.
Mortgage companies will also compare debt load to annual income. They’ll typically loan up to three times what a person makes in a year. So if a home buyer earns $30,000, they might qualify for a $90,000 mortgage.
Article used with permission from Practical Money Skills Canada