How To Manage Your Debt/Income Ratio
What Is This Ratio?
Many people do not fully understand what their debt to income ratio is and why it is so important. This ratio is simply the amount that you must pay per month to meet all debt obligations divided by your income. To calculate your own ratio you could simply do that. Add up all of your monthly debt payments such as mortgage, credit cards, car payments, student loans, etc. and then divide that number by your monthly income.
What is a Good Ratio?
While a perfect ratio of course would be 0, most people will need to take out debt to accomplish their goals and that is okay! The baseline recommendation is to keep your total debt to income ratio below 36%. For most people a majority of their debt arises from their house or rent. Your total housing costs (mortgage payment, home insurance, and property taxes combined) should be less than 28% of your income. Therefore, ideally the total debt payments from sources other than your home would total 8% or less of your income.
How to Manage My Ratio
There are a few keys to ensuring that you do not fall into a hole of having too much debt. The largest debt potential is your home. Lenders may approve you for an expensive house, but that does not mean it is a wise decision to utilize the entire loan that they offered. Oftentimes when people use the entire loan available to them they end up in a situation that is called being “house poor” later down the road. This occurs when the payments for your home take up a larger portion of your income than what is recommended. Once this happens, in order to continue meeting payments you must reduce other living expenses, savings, etc. At this point you are living in a nice house but are always running a cash flow deficit due to the large payments.
Imagine you are in a situation where you have just purchased your dream home. The only issue is the mortgage payment is as high as you can possibly budget for, and you have yet to account for landscaping, new furniture, redoing some of the rooms, and higher property taxes. At this point in order to even make ends meet you need to cut back drastically on expenses. As a result, you end up having to stop contributions to your company’s 401k plan. Because of this, you also no longer receive the company's match which is essentially turning down free money. Additionally, it drastically slows down your path to retirement and you will likely need to modify your financial goals to be able to make ends meet. Having a debt ratio that is too high is a slippery slope, and once you start down this path it can be very difficult to right the ship.
The other problem that is common is when credit card users allow their balance to accrue and then they start being charged upwards of 15-20% interest on their amount owed. Obviously, the best preventative measure for this is to pay off your credit cards in full every month before the interest has any chance to accrue. Credit cards are useful through receiving cash back and allowing you to build your credit, but they can become very dangerous if they are not always paid off immediately.
If you find yourself in a situation where you have already taken the loans or used the credit cards and now have payments above the recommended 36% maximum, there are still things you can do. You must establish an aggressive payment plan. This could mean reducing savings for a short period of time while you pay as much as possible towards the mortgage. Additionally, you could take a short savings hiatus and utilize all excess cash flow to completely pay off the credit card bill that is accruing at a high interest rate.