Having some debt to your name isn’t always a bad thing. After all, many people need to borrow money to go to college, buy a car, become a homeowner and more. But it’s definitely easy to cross the line into having too much debt ― too easy, unfortunately.
Dealing with high monthly payments can put a strain on your finances, but there are other ways a high level of debt can work against you. For instance, too much debt can cause your mortgage application to be denied or your credit score to drop.
So what’s the right amount of debt to have? Fortunately, there’s a simple formula that can tell you.
What Is A Debt-To-Income Ratio?
Your debt-to-income ratio, commonly referred to as DTI, measures how much of your income gets eaten up by debt payments. It compares your monthly gross income (your income before taxes are taken out) to your total monthly debt obligations. The higher your DTI, the more burdened you are by debt. The formula looks like this:
DTI = Monthly Debt Payments / Monthly Gross Income
Though there’s no hard-and-fast rule, the general guideline is that a healthy DTI is under 36 percent. Borrowers with a DTI higher than that are usually considered at risk for missing payments because they’re overextended financially. So if you apply for a loan or other type of credit with a DTI over 36 percent, there’s a good chance you’ll be denied.
When it comes to mortgage lenders specifically, most allow a DTI of up to 43 percent when you include payments on the mortgage you’re applying for (also known as the back-end ratio). However, your front-end DTI ― how much of your income goes to housing costs only ― should be no higher than 28 percent.
It’s also important to point out that some personal loan companies will consider a DTI of up to 50 percent since personal loans are often used to consolidate debt. However, a DTI that high is not good, and the goal of debt consolidation should be to pay it down ASAP.
How To Calculate Your DTI
To calculate your own debt-to-income ratio, start by adding up all your monthly debt payments, including auto loans, student loans, credit cards, mortgages and any court-ordered child support or alimony.
Next, add up all sources of your monthly gross income, including paychecks, freelance income, rental property and investment income.
Finally, divide the total monthly debt by the total monthly gross income. You can carry the decimal point two digits to the right to see your DTI as a whole number percentage.
Let’s look at an example. Say you have two credit card payments of $50 and $75 per month, plus a car loan payment of $150 and a student loan payment of $300. Your monthly debt obligations total $575. You earn a monthly gross salary of $4,000, plus $750 on the side from freelancing, for a total of $4,750 per month.
Your DTI calculation would look like this: $575 / $4,750 = 0.12.
That’s 12 percent, and a DTI of 12 percent is considered healthy. In this case, you shouldn’t have any trouble managing payments or obtaining new credit in the future (in theory, anyway).
Here’s a debt-to-income calculator that will do the math for you.
Other Debt Measurements You Should Know
Your debt-to-income ratio can be a good measure of your financial health, but it doesn’t provide the whole story. DTI doesn’t take into consideration other non-debt-related expenses, your credit score and other factors that can impact your overall financial situation. Still, it’s a good number to know, and one that can have a very real impact on your life.
If you’re interested in getting a more well-rounded look at your debt situation, there are a couple more easy formulas you can use.
The current ratio measures how much you currently have in liquid assets compared to your liabilities. In other words, it gives you an idea of whether you have the cash on hand to cover your bills in the case of a financial emergency. The formula looks like this:
Current Ratio = Liquid Assets / Current Liabilities
In order to calculate your current ratio, first add up all your liquid assets. This includes cash and anything that could be converted to cash quickly, such as bank accounts, stocks, bonds or mutual funds.
Next, add up all your liabilities. This is the same process as when you added up your debts for the DTI calculation, except in this case, you’ll want the yearly total.
Finally, divide your assets by liabilities. Ideally, the result should be 1.0 or higher, which means you have enough money to survive a financial emergency such as losing your job. If you get lower than 1.0, you either have too much debt or not enough assets. Either way, you could find yourself in a tight spot if things go wrong, potentially causing you to take on even more debt.
Your debt ratio compares your total debt to total assets. The lower the ratio, the less dependent you are on debt. Here’s the formula:
Debt Ratio = Total Liabilities / Total Assets
To calculate your debt ratio, once again add up your total liabilities for the year. Next, total your assets, including both liquid and illiquid assets such as property, vehicles and anything else of value that you own.
Lastly, divide the total liabilities by the total assets. Ideally, the result should be 1.0 or less, which indicates you’re using debt as a tool and not relying on it too heavily.
What To Do If Your Debt Load Is Too High
If you try out any of these calculations and the results point to a possible debt problem, there are two main ways to remedy the situation.
Alternatively, you can focus your efforts around paying off your debt. That will also help to lower DTI, as well as reduce the burden of high monthly bills. Use a strategy such as the debt snowball or debt avalanche to pay it off faster.
Don’t worry if it all seems overwhelming; getting your debt under control won’t happen overnight. Take it one step at a time. You’ve got this.