In the perfect world, we’d all be debt free.
For most of us though, we can’t get by without it. The question is, how much debt is enough? As they say, a little bit of something is alright, but too much is another story.
The debt to income ratio
Two major components of tracking how you’re doing financially can be broken down into your income and debt levels. Obviously, you’d like to have more income coming in than debt payments going out, but even if you are making more money than you owe, how can you tell if that’s good enough?
That’s where the debt to income ratio can come in handy.
This quick calculation can give you an idea of where you stand and can be helpful in helping you with other financial decisions such as figuring out how much money you can borrow to buy a house. While it won’t give you a terribly detailed picture of your financial situation, it can be used to quickly gauge how you’re doing.
Calculating Your Debt to Income Ratio
Calculating your debt to income ratio is as simple as adding up all of your debt and subtracting it from your income. So, to get started, take a moment to gather all of your monthly debt obligations. This will include monthly payments such as:
When you add these all up it will give you your total monthly debt payments. Keep this number handy as we’ll be using it in just a minute.
Next, you need to calculate your monthly income. Start with your monthly salary. If you receive any additional bonuses on a yearly or quarterly basis, be sure to divide it out to get the per month number. Finally, add up any additional income you receive, whether through dividends, a side business, or whatever the case may be. Total these all up and you will have your total monthly income.
To determine your debt to income ratio simply take your total debt payment number and divide it by your total monthly income.
That equals your debt to income ratio. For example, if you came up with a $2,000 total debt payment number and monthly income of $6,000, that leaves you with a debt to income ratio of 33%.
Why Debt to Income is Important
So you’ve calculated your debt to income ratio, but what does that number mean? Obviously, this is a number you want to be as low as possible. The less debt you have relative to your income, the better off you are financially since you have extra money to apply toward other goals. But it’s also important in terms of deciding how much of debt you can afford.
While none of these numbers are set in stone, as a rule of thumb;
Remember, loan rates are at record lows. Re-do this calculation at a home loan rate at say 6 or 7% (you can use the calculators here to work it out). What’s the number now?
Your debt to income ratio isn’t the only thing that is important. Another important ratio is the loan to value ratio. This looks at how much you’re borrowing relative to the value of what you own. That’s for another day.