What is a debt to income ratio? Simply put, it is generally a measure that lenders will use to determine whether it is safe to lend you more money.
But does it have any use outside of lending? Can we use it in our own households to assess our situation and if we are in debt, whether we can handle it ourselves or need to seek help like a debt consolidation loan?
The answers are Yes.
First we are going to need to modify the traditional debt to income ratio calculation. Most lenders use GROSS income to calculate this. I’m not sure why, since gross income does not take into account what we actually get to keep at the end of the month.
For this reason, it is safer to use our net income, or more specifically, our pay minus federal, state and local income taxes. This is the true number we have to use. In this calculation, you should add back any income you receive as a tax overpayment (refund), in order to be more accurate.
While it’s nice to pretend like we actually make more, it’s best to level with yourself and start thinking about your income as NET income.
Debt to Income Ratio in Real Life
So let’s look at a fictional family, the Joneses (because we like to pick on the Joneses). After taxes, their monthly take-home pay is $3,000. If we annualize this (multiply it by 12), they take home $36,000 per year. This puts them near the median household income in the US, which hovers around $50,000.
Before we move on, let’s take a look at some average or median consumer debt statistics (link temporarily disabled due to a warning on that site) for the United States:
- Average credit card debt per household with credit card debt: $15,799
- Average total debt in 2009 (including credit cards, mortgage, home equity, student loans and more) for U.S. households with credit card debt: $54,000. (That's down from $93,850 in 2008.)
- Average total debt in 2009 (including credit cards, mortgage, home equity, student loans and more) for all U.S. households: $16,046. (That's down from $35,245 in 2008.)
Let’s take a look at the Joneses. Let’s say they have $15,000 in credit card debt, $25,000 in student loans, and $20,000 in car loans. That gives them a total consumer debt of $60,000, not too much above the average total debt of $54,000 for households with credit card debt (but we haven’t even taken into account their mortgage).
Now let’s figure out their REAL debt to income ratio, using their take home pay. We will use the formula (Total Debt/Take Home Income = REAL Debt to Income Ratio).
So, $60,000/$36,000 = 1.666666… or 166%. That’s right, their consumer debt (not counting mortgage) is over one and a half times their yearly income. Needless to say, paying off this debt is going to be very tough for this family.
I think many of us have been in this position before. Imagine if they had a boat or a motorcycle, adding another $20,000 to their debt. I think many of us know people who fall into this range as well.
Should We Panic?
As I mentioned before, figuring out your true debt to income ratio is an exercise to see whether you can pay off your debts yourself. I honestly believe that a family with a stable income, even if they owe up to 200% of their income, can get out of debt with diligence. Sure it’s going to take a few years of sacrifice, and some things will need to be sold off, but it can be done.
Though I abhor all consumer debt, not everyone feels that way. If you are at 10% or lower debt to income ratio, you are probably okay and can easily turn your situation around if you want. If you are at 25%, it’s probably time to enact a plan to get out of debt.
But imagine a family with 300, 400, or even 500% debt to income ratio. This family likely experienced a sharp drop in income through a job loss, or some crushing medical bills.
These families will likely need help like debt consolidation or even bankruptcy. They face immediate concerns like repossession, foreclosure and homelessness. Keeping their family together and sane should be their first priority.