How Much Debt Is Too Much?

• The debt-to-income formula is a great scorecard to manage debt.  
• Debt payments that are less than 10% of your income are within the healthy range. 
• Debt that's 15%or more of your income can be dangerous, and even unsustainable.

When you apply for a loan, one of the first steps your lender will take is to check if you’re able to pay back the loan.  The larger the loan amount and the longer the loan period, the more extensively the bank will evaluate your paychecks, spending habits and credit history. 

In addition to reviewing your cashflow and repayment history, the bank will analyze your current debt, and compare your total debt payments to your income.  This comparison of debt to income is also referred to as your DTI ratio.  Let’s take a closer look at how DTI ratios are calculated, and how they can help you manage your finances. 

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Calculating Your Debt-to-Income Score

Debt-to-income formulas and limits vary by lenders, but generally, all lenders follow the same approach of adding your total monthly debt payments, and then dividing those payments by your monthly income to determine your financial health.  Lenders don’t include expenses such as rent, utilities, groceries and entertainment in this calculation, as these expenditures are not debts that must be repaid to a lender.  Additionally, lenders often exclude mortgage principal and interest from the calculation and instead focus on personal consumer debt.

How to Use Your Debt-to-Income Ratio 

So now that you know how to calculate a debt-to-income ratio, let’s put your money to the test and compare your after-tax income to your monthly debt payments.

Step 1:

Add up all your minimum debt payments.  This will include your credit cards, personal loans, student loans, medical debt, auto loans, furniture loans, and even payday loans.  Gathering old bank statements and credit card statements will help in determining your debt payments. 

Step 2: 

Divide your total monthly debt payments by your take-home pay.  Your take-home pay is your income after taxes, required withholdings and any other deductions.  You can calculate your monthly after tax income by dividing the annual after-tax income shown on your W2 statement or 1099 statement, by 12.  

The resulting number from this calculation explains what percentage of your take-home pay is being used to pay debt.  A lower number is your goal.  

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Interpreting the Results

The DTI ratio provides a useful tool to gauge how much debt you have, and whether it is safe to incur more debt or to instead press the brakes and reduce your balances.  A small DTI number means that less of your money is being used to pay off creditors, and more is being kept to cover your living expenses such as rent and utilities, as well as savings and investments.  The smaller the percentage of money being used to pay creditors, the more that can be used to reach your financial goals. 

If your DTI score is 0.10 or less, this means that ten percent or less of your income is spent on debt payments, which represents a healthy level of debt.  As an example, if you have $200 in monthly debt payments and $2,000 in after tax income, dividing $200 by $2,000 equals 0.10, translating into 10% of your income being spent on debt payments. 

If your DTI score is between 0.11 and 0.14, meaning 11% to 14% of your net income is spent on debt payments, think of this range as a caution flag, and slow down on taking on any more debt.  As a for instance, if you have two credit cards, consider reserving one of them for emergencies, and begin using it rarely and only when required. 

If your ratio is between 0.15 and 0.18, or 15% to 18%, this represents a hefty percentage of debt.  Your financial plan should focus on paying off your balances and steering clear of any new debt.  

If your DTI score is above 0.19, focus on aggressively paying down your balances.  If you’re stumped on how to get started, a trained financial coach can be helpful in outlining a strategy.  

If your ratio is close to 30% or above 30%, consider this the red or danger zone, with your debt approaching an unsustainable level.  A certified financial planner or other debt management professional can help you review your options. 

Digging into the Numbers

Let’s look at an example to see a DTI ratio and financial plan in action.  

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Meet Sean.  Sean brings home $2,000 a month after taxes.  He would like to buy a house one day, but first wants to make sure that he understands his spending, and gets on top of any debt issues.  Sean’s monthly debt payments are as follows:

• student loan payments of $125
• a department store card payment of $25
• a personal loan payment of $50
• a credit card payment of $50 per month. 

These payments add up to $250 a month.  Sometimes Sean makes extra payments on his credit card and retail store card.  However, since the DTI ratio focuses on required debt payments, Sean excludes  these additional payments from the formula. 

Sean’s divides his $250 in required debt payments by his after tax income of $2,000, yielding a result of 0.12.  This figure means that 12% of Sean’s income is is going towards debt payments.  Not bad, but he knows he’ll have to reduce this number in order to enhance his application when he applies for a mortgage.  Sean decides to come up with a plan to pay off his personal loan early, and put those funds towards the savings account he has already started for his mortgage down payment. 

Wrapping it All Up

The debt-to-income formula is a great benchmark for checking whether your debt payments are in the green, yellow or red zone.  Debt payments that comprise less than 10% of your income represent a healthy level of debt.  Debt that consumes 15%or more of your net income can be dangerous, and even unsustainable at levels upwards of 30%. 

You can use your DTI score to brainstorm strategies to increase your income and reduce your debt.  Before making any new purchases, particularly those that will require a loan or the use of your credit card, use the DTI formula to calculate how this new debt will affect your score.  For example, if upgrading your cell phone with a newer model will add $25 in monthly credit card payments, causing your DTI score to rise above 20%, consider pressing pause on this purchase until you increase your income or lower other debt payments.