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Debt: The 20-percent solution
Dear Debt Adviser:
What debt-to-income ratio should a family shoot for each month/year?
Ferman
Dear Ferman:
Yours is a good question and one that many families should be asking.
A high debt-to-income ratio is something that almost all people
who have financial problems have in common.
As a rule of thumb, you should strive to keep your
debt at or below 20 percent of your income level. Depending on other
monthly expenses and how much cash flow is unallocated, some families
may need a lower ratio, while some can get by with a higher ratio.
Here is how to determine your debt-to-income ratio:
- Add up all your sources of monthly take-home income.
For a family this would include payroll checks, dividend or stock
income, alimony or child-support payments and capital gains (home
or other property sale).
- Then add up your debt, excluding mortgage or rent.
Make sure to include all debts such as credit cards, personal
loans, student loans, medical bill payments for services already
rendered and car loans. You would include only your total monthly
payment on loans and credit cards when totaling your debt.
- You should now have two figures, the larger of
which had better be income. Divide your debt by your income to
get your debt-to-income ratio.
For example, let's say a person has a monthly of income,
after taxes and all deductions, of $4,000, and debts totaling $800
per month. Divide $800 by $4,000 and you have a total debt-to-income
ratio of 20 percent. If the person in this example had monthly debt
payments of $900 to $1,000 a month or a debt-to-income ratio of
22 percent to 25 percent he or she may find it difficult to make
monthly debt payments.
Keep in mind that debt payments are not the only monthly
expenses paid by a family. All expenses should be considered when
finding a comfortable debt-to-income ratio. For instance, a family
with a large portion of its income going to a mortgage payment may
be able to comfortably pay only 10 percent of their income in debt
payments. Likewise, a family with a small mortgage or a home on
which the mortgage is paid off may be more comfortable with paying
more than 20 percent in debt payments.
One reason to keep your debt-to-income ratio in line
is that lenders look at this percentage when deciding whether to
lend you money. A high ratio could mean you will not qualify for
the mortgage, car or other loan.
A top-heavy debt-to-income ratio also makes you vulnerable
to changes in your income or expenses. It's like standing on one
leg. As long as nothing changes or bumps into you, things are fine.
Take a bump and you will end up on the floor. By its very nature
one thing is certain in a time of financial uncertainty and that
is that things tend to change. My experience leads me to advise
you to have both feet on the ground when that change bumps into
you!
The bottom line is to try and live below your means
and not above them. If you calculate your debt-to-income ratio at
20 percent or less, have no trouble meeting your monthly bills paying
more than the minimum on your credit card balances, have money set
aside in savings for emergencies and are contributing to a retirement
account, then your ratio is probably fine.
Keeping tabs on your ratio once or twice a year or
when things change, can help avoid problems. Your financial circumstances
may change due to job loss, illness or divorce, and you would want
to recalculate your debt-to-income ratio and make changes in your
spending habits to bring the ratio back in line. By the way, that
emergency savings cushion I mentioned earlier is a great tool to
help you stay at a steady ratio.
The Debt Adviser, Steve Bucci,
is the president of Consumer Credit Counseling Service of Southern
New England. Visit CCCS
for additional debt
advice or click
here to ask a debt question.
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