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.
The first step is to calculate your debt load. This 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 do this 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 debt payments - including credit cards, mortgage 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.
- Take your monthly payments total and divide it by your monthly income.
- Move the decimal point two digits to the right to make it a percentage. That's your debt/income ratio.
Here's an example. Let's say your monthly income is $2,000 and your monthly payments on your debt load totals $500. If you divide 500 by 2,000 you get .25. Move the decimal point two places to the right and you get 25% as your debt/income ratio.
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.
But as a general rule of thumb, a debt/income ratio of 10 % or less is outstanding. If it's between 10 - 20 %, your credit is good, and you can probably borrow more.
But once you hit 20 % or above, it's time to take a serious look at your 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.
The 28/36 Rule
Another helpful guide is one mortgage lenders use: the "28/36 rule." It stipulates that your debt shouldn't exceed 28% of your gross monthly income, while your total debt service - including your house payments and utilities - shouldn't be more than 36 percent.
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.
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