How much debt is too much debt?
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How can you determine if you are getting into too much debt? A good benchmark to use is your debt-to-income ratio (DTI). This ratio compares the amount of money you pay toward debt and the amount of money in your take-home pay. Learn how to calculate this ratio and see how much debt you can safely handle.
How to calculate your debt-to-income ratio
Start by making a list of your monthly household debt payments. Remember that debt is only the payments you make to repay a lender for money that you've borrowed. Monthly expenses such as rent or groceries are not classified as debt, so those wouldn't be included in the DTI. Furthermore, when calculating your DTI, you don't include all types of debt. Do not include your home mortgage payment. But do list credit card debt, auto loans, student loans, medical bills, or any other debt you are making a monthly payment on.
Next, calculate your monthly take-home pay (this is your net income). Once you have these two figures, divide the total debt payments per month by your monthly net income. You will likely get an answer that equals less than one (such as 0.35 or 0.23). Now, multiply this number by 100 to see the percentage of your take-home pay that goes to pay down debt. Ideally, financial experts like to see a DTI of no more than 15 to 20 percent of your net income. For example, a family with a $250 car payment and $100 of monthly credit card payments, and $2,500 net income per month would have a DTI of 14 percent ($350/$2,500 = 0.14 or 14%). The $350 of debt is 14 percent of the $2,500 monthly income.
How to use your debt-to-income ratio
The DTI is a very useful tool because it lets you know how much debt you currently have and how much more debt you can safely take on. Use this formula before deciding whether to make a new purchase using credit. For example, if you estimate that an extra $50 in monthly credit card payments will increase your DTI above 20 percent, you may want to wait to buy that new item until your net income goes up or your total monthly debt payment goes down.
Not all debt is bad! Some debt, such as a home mortgage, is necessary for some families. However, you need to be a smart borrower so you don't wind up with more debt than you can handle. Calculate your DTI and estimate how taking on more debt will change before borrowing money or purchasing on credit.
Consumer Financial Protection Bureau. (n.d.). What is a debt-to-income ratio?
National Endowment for Financial Education. (2010). The money you borrow. In Your spending, your savings, your future: A beginner’s guide to financial readiness.