A faithful Wealth Pilgrim reader asked me recently what a good debt to income ratio is. I did a little research and come up with an answer which I will share with you. Then, I want to explain why it doesn’t matter. First things first.
What is a debt to income ratio?
Your debt to income ratio is a fraction used by banks and other financial institutions to gauge whether or not they think you are credit worthy. The higher the ratio, the more debt you have relative to your income and the more risky they think you are. The lower the ratio, the more attractive you are to them and the more willing they are to advance you some cabbage.
When these institutions calculate this ration, they consider the following as elements:
- Monthly rent or mortgage.
- Monthly car loan payments.
- Minimum monthly credit card payments.
- Other debts you are required to service.
On the income side, they consider the following:
- Annual gross salary
- Bonuses and overtime.
- Other income.
(Here’s a link to a spreadsheet that will help you calculate your own debt to income ratio.)
What is a good debt to income ratio?
According to US News, a debt ratio of 36% or less is healthy. So if you earn $5,000 a month and have debt payments of $1800 per month (including rent etc.) you would be golden.
If you are between 37% and 42% your situation isn’t great but you are not in the red zone either. If you carry 43% to 49% you are flirting with disaster unless you take immediate evasive action. And if your debt to income ratio is 50% or worse, your ship has run aground. Game over.
If you have a high debt to income ratio, here’s a post that might help you reduce your cost of debt big time.
Why it doesn’t matter.
I don’t know what my debt to income ratio is and I don’t care. That’s because it’s always better to have less rather than more debt.
There are a few exceptions to this.
Borrowing money to buy a house is fine as long as you can afford the payments. And borrowing money to buy a business can also be a shrewd move under the right circumstances.
Sometimes you have no choice but to take a loan. Borrowing money to buy a car (if you have no other option) might be smart if you buy the cheapest/safest car that you can and you need it to get to school or work. Sometimes going in to hock for school is smart – but far less often than most people think. And of course there are other emergencies.
If you are in one of these situations, you do what you have to do. You should never take a loan if you don’t have to.
Debt is something you should avoid like the plague in almost all cases. The only time it can be smart to take on debt is when you don’t have cash and you absolutely must go forward with a transaction. Once you do that, focus your energy on eliminating that debt. Don’t worry about your ratios. And if your ratio is high and you are doing everything you can to slash that debt, relax. What more can you do than your best? Nothing.
Do you track your debt to income ratio? Why or why not?