How much debt is too much? The debt-to-income ratio (DTI) formula will help you determine if you have too much debt for your income level. It’s not only useful to assess your personal finance; it’s something lenders use when considering whether to approve you for new credit.
A manageable debt-to-income ratio is typically described as less than 35%. Lenders might prohibit certain borrowing actions once you hit 50% or more.
This article could help you calculate your debt-to-income ratio, determine how much debt is too much, and help you take steps toward becoming debt-free.
How exactly do you determine the ratio of your debt to income? First, add up all your total monthly debt payments. Then divide them by your total monthly gross income. Multiply the resulting number by 100 to get your DTI percentage.
For example, if you have debt payments of $2,000 a month and a gross monthly income of $4,000, your debt-to-income ratio is 50%. It’s important to note that this example is a simplistic way to demonstrate your debt-to-income ratio. Each lender may approach your verifiable debt and income in its own calculation, so the results may vary.
If you have too much debt and want to lower your DTI, you need to raise your income, reduce your debt, or both. There are debt management strategies including:
While you want to maintain a manageable debt-to-income ratio, not all debt is bad.
Not all debt is inherently bad. Good debt is an investment. It puts you in a position to benefit and improve your financial situation. Bad debt, on the other hand, costs you money. Here are some examples of each.
Debts such as a mortgage, small business loans, and student loans can help you in the future. Of course, there’s an inherent risk: You're assuming your investment in your career or home will pay off, but that might be a risk worth taking.
Bad debt is debt that doesn’t provide any value to you. It’s not an investment, but a way of “buying time” to purchase something or pay bills.
Different kinds of debt can require different approaches. Some loans are secured, meaning what you’re purchasing serves as collateral in case you can’t pay. Others are revolving credit, like credit cards. It’s essential to understand interest rates and payment plans for each type of loan before creating a plan to pay off your debt.
If you are unable to pay what you owe upfront, healthcare providers often have billing departments that are willing to work with patients to come up with a payment plan for their medical bills.
Although credit cards may be considered good debt if you pay your balance in full each month, not paying the entire balance adds interest to your debt that may quickly accumulate.
If you’re in over your head, you may want to talk to your credit card issuer and see if you can work out a payment plan. Credit card issuers may choose to close your account if you’ve failed to keep up with payments, which could negatively impact your credit score.
If you have debt from one or multiple lines of credit, you may want to consider a balance transfer, which moves debt to a new card with zero or low interest. Understand the balance transfer fee and any fees that may be incurred after the introductory period is over to determine if this is a good option for you.
There are two different types of student loans: private loans and federal loans. Private student loans are like other private installment loans.
Federal loans offer many repayment plans including income-based and extended plans, so explore your options to determine what best fits into your debt repayment strategy.
As a general rule, financial experts suggest that you should allocate between 10% to 15% of your gross income on car payments, which include principal, interest and car insurance. You can pay off your car loan faster by doing things like rounding up your payments, making an extra payment each year, or refinancing your loan to a lower rate.
As a general rule, you can afford a mortgage that’s twice to 2½ times your annual gross income. So if you had an income of $60,000, you could afford a mortgage of $120,000 to $150,000. However, you must personally consider several factors when calculating how large of a mortgage you can afford. This calculation doesn’t take into account your unique financial situation and should only be considered a general guideline.
If you have a high interest rate, you may want to consider refinancing to a lower one. If you put less than 20% down, you will have to pay private mortgage insurance. Understand when your private mortgage insurance (PMI) falls off and if you can remove it earlier than planned.
The most obvious sign that you have too much debt is that your debt-to-income ratio is higher than 35%. Your debt-to-income ratio is the percentage of your monthly income before taxes that goes toward paying your monthly debt payments. Other warning signs include using most of your available credit, causing a high credit utilization ratio. Here are a few more subtle signs that can indicate your debt is unmanageable.
The first step to paying down your debt is knowing how much you have. Use our debt tracker to record various debts and track your progress towards paying them off.
The amount of debt you owe affects your credit utilization ratio, which determines 30% of your FICO® score, second only to your payment history in importance, which determines 35% of your score. If you have a high credit utilization ratio — the ratio of what you owe on all your credit cards divided by your total credit limit — it will likely hurt your credit score.
Other factors that make a difference in the “amount owed” category include the amount of debt you have on different kinds of accounts, such as installment loans and revolving credit, and whether you have balances on a large number of accounts. Being aware of these factors puts you in a position to boost your credit score.
Knowing how much debt is too much depends on a variety of factors. Calculating your debt-to-income ratio is a good starting point. From there, you can begin assessing the different kinds of debt you have and work to align them with what experts recommend (the 50-30-20 rule is one example).
Cutting back on things you don’t need; finding ways to reduce interest rates on loans you have, and paying them down more rapidly; and being judicious about new debt are all steps you can take to improve your financial situation. If you’re struggling to do these things yourself, you can try credit counseling.
Many resources are available to help you manage debt, so you don’t have to do it alone or feel like you’re in the dark. Attacking debt doesn’t have to be intimidating. Once you start to make progress, it can be exactly the opposite: empowering.
Ana Gonzalez-Ribeiro, MBA, AFC® is an Accredited Financial Counselor® and a Bilingual Personal Finance Writer and Educator dedicated to helping populations that need financial literacy and counseling. Her informative articles have been published in various news outlets and websites including Huffington Post, Fidelity, Fox Business News, MSN and Yahoo Finance. She also founded the personal financial and motivational site www.AcetheJourney.com and translated into Spanish the book, Financial Advice for Blue Collar America by Kathryn B. Hauer, CFP. Ana teaches Spanish or English personal finance courses on behalf of the W!SE (Working In Support of Education) program has taught workshops for nonprofits in NYC.
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