Debt to income ratio?

InDebtInDC · #1 (**permalink**) 03-08-2008, 11:14 AM

Does anybody have any literature or comments towards using one's income as a gauge for one's level of debt?

For example, $100K in debt may sound like a lot to us, but is it really that much for someone who makes $100K a year? What about a $1 million debt for someone who makes $1 million a year?

How about $10K for someone who only makes $15K per year?

Would it also depend the nominal amount as well as the percentage of income?

Broken Arrow · #2 (**permalink**) 03-08-2008, 11:26 AM

I think that's a very good point, and it's something I've also wondered about in the past, because I don't hear it get mentioned too often.

What do you guys think of this explanation?

Here's an online calculator.

disneysteve · #3 (**permalink**) 03-08-2008, 11:27 AM

I think it depends on many factors. The type and terms of the debt are important. A $100,000, 30-year, 5% mortgage is a lot different than $100,000 in credit card debt at 18% or more. What percentage of the home's value that mortgage represents is also important.

For the purposes of getting a mortgage, the traditional guidelines have always been that the housing costs shouldn't exceed 28% of income and total debt servicing shouldn't exceed 36% of income, so I think that's one way to judge if someone is carrying too much debt relative to income.

InDebtInDC · #4 (**permalink**) 03-08-2008, 11:37 AM

Quote:

Originally Posted by disneysteve

housing costs shouldn't exceed 28% of income and total debt servicing shouldn't exceed 36% of income, so I think that's one way to judge if someone is carrying too much debt relative to income.

Are housing costs included in that 36%? According to the article posted above it does.

Quote:

Originally Posted by Broken Arrow

Here's an online calculator.

According to this my ratio is exactly at 36%! I've been known to cut it really close

disneysteve · #5 (**permalink**) 03-08-2008, 11:43 AM

Quote:

Originally Posted by InDebtInDC

Are housing costs included in that 36%?

Yes. 28% to housing and the rest, up to 36%, to other debt.

disneysteve · #6 (**permalink**) 03-08-2008, 11:44 AM

Quote:

Originally Posted by InDebtInDC

According to this my ratio is exactly at 36%! I've been known to cut it really close

That's okay, though. Over time, income tends to rise. Fixed debt, like a mortgage, gradually becomes a smaller percentage. And hopefully other debt is getting repaid also.

Snave · #7 (**permalink**) 03-08-2008, 03:39 PM

Don't know where "net worth" or wealth falls into the scenario either. I guarantee there are folks out there that make 30-40K a year, have been saiving for many, many years and have a sizeable nest egg, but still have a mortgage. So, if you looked at their 30-40K income and compared it to the 100K left on the mortage, it might look like they have a lot of debt. But, they could easily have hundreds of thousands in retirement funds, etc...

jIM_Ohio · #8 (**permalink**) 03-08-2008, 06:12 PM

It's easy if debt ratio is zero percent.

I would also think the changing of the ratio over time is more important than the ratio itself.

If I started at 60% when I left college, and have it to 25% now, that is more important than what my actual number is, correct?

LivingAlmostLarge · #9 (**permalink**) 03-09-2008, 08:38 PM

I agree with Jim, although if you got a mortgage and didn't have one right out of college, you just increased your debt ratio.

Tree0164 · #10 (**permalink**) 03-10-2008, 01:58 AM

Quote:

Originally Posted by disneysteve

For the purposes of getting a mortgage, the traditional guidelines have always been that the housing costs shouldn't exceed 28% of income and total debt servicing shouldn't exceed 36% of income, so I think that's one way to judge if someone is carrying too much debt relative to income.

I think too many people forget about these guidelines of course the mortgage industry did the last few years.

jIM_Ohio · #11 (**permalink**) 03-10-2008, 06:15 AM

Quote:

Originally Posted by Tree0164

I think too many people forget about these guidelines of course the mortgage industry did the last few years.

The mortgage industry is known for taking on more risks to get money. The S&L situation in the 1980's or the real estate bubble of the 21st century. Both were about banks finding a way to make money.

In both cases the government is going to bail them out, so in reality they took on less risk than is being exposed now.

SnoopyCool · #12 (**permalink**) 03-10-2008, 06:34 AM

Our ratio was 24%, with a mortgage and student loans. I am glad for that number!

noppenbd · #13 (**permalink**) 03-10-2008, 06:36 AM

I think Debt as a percentage of assets is a good number to look at. It takes into account net worth and debt. Not sure what to shoot for but mine is around 40% right now. I guess the lower the better! I think this is more useful than looking at income (which someone could be completely outspending no matter how high, and which can change at any time).

Looking at your net worth relative to your income is a good indicator of financial health. From "The Millionaire Next Door", AAWs (average accumulators of wealth) have net worth = gross income * age / 10. So if you are 40, make $100K a year, your net worth should be around $400K to be an AAW. Lower than that makes you a UAW (under) and higher is a PAW (prodigious). I think this is less useful the younger you are.

Lastly, I have heard that when you are young (25-40) your net worth should be increasing by 25-30% a year. As you age and (hopefully) accumulate assets, this will go down as a percentage to around 15-20.

InDebtInDC · #14 (**permalink**) 03-10-2008, 09:06 AM

Quote:

Originally Posted by noppenbd

net worth = gross income * age / 10

This sounds like a good idea, but does it take into account people who are young and just started working? For example, a 25 year old making $100k at his first job should have already accumulated $250k according to that equation.

Is that a realistic expectation?

Quote:

Originally Posted by noppenbd

Lastly, I have heard that when you are young (25-40) your net worth should be increasing by 25-30% a year. As you age and (hopefully) accumulate assets, this will go down as a percentage to around 15-20.

Does reducing debt, like paying back student loan, contribute to the net worth? And how do you calculate a percentage increase in net worth for someone who has a negative net worth?

noppenbd · #15 (**permalink**) 03-10-2008, 09:15 AM

Quote:

Originally Posted by InDebtInDC

This sounds like a good idea, but does it take into account people who are young and just started working? For example, a 25 year old making $100k at his first job should have already accumulated $250k according to that equation.

Is that a realistic expectation?

No, probably not. It is more of a target to shoot for. I think it probably holds best for those in the 45-65 age range (peak earnings).

Quote:

Originally Posted by InDebtInDC

Does reducing debt, like paying back student loan, contribute to the net worth? And how do you calculate a percentage increase in net worth for someone who has a negative net worth?

Generally net worth is assets - liabilities, so increasing assets or decreasing liabilities/debts will raise your net worth. I have seen some figures which exclude your principal residence (both as an asset and as a liability) on the grounds that it is an ongoing need rather than a true investment (you will always have some kind of housing costs). I include it for my own calculations because it makes my net worth higher

.

As far as a negative net worth you are increasing the percentage by a infinite amount any time it goes up! How's that for motivation? I think I would look at your net worth increase month-over-month and year-over-year on an absolute basis until you get into positive territory. That should help keep you motivated.