In our last article, we discussed that the first steps to creating wealth are making provisions for emergency funds and managing debt. Here we take a closer look at debt and measure your debt-to-income ratio (DTI) as the first step to address your debt.
Some debts can be helpful, but most are not. So, we’ll also discuss the difference between prudent debt and bad debt. Identifying a problem is the first step in solving a problem.
We’ll start by listing all your debt, including the minimum monthly payment, the interest rate, and the remaining balance. We’ll use this list below and in our debt reduction plan later.
Then, in the next article, we’ll tackle the bad stuff with specific debt reduction plans that really work.
Debt-to-Income Ratio
If you meet with a financial planner or credit counselor, they’ll want to look at your debt-to-income (DTI) ratio. The DTI ratio is how much you owe compared to how much you earn.
DTI measures your ability to repay new debt, and the ratios are widely used. However, lenders can set their own DTI limits for certain types of loans.
Since lenders set the limits for loan approvals, financial planners and credit counselors usually adopt those limits and use them as their guidelines, too.
How to Calculate Your Debt to Income Ratio
Your DTI ratio is all your monthly debt payments divided by your gross monthly income.
DTI Ratio = (Total Monthly Debt Payments / Gross Monthly Income) X 100
To calculate your debt-to-income ratio, add up all your monthly debt payments and divide them by your gross monthly income. The gross monthly income is the amount earned before taxes, and other deductions are taken out.
For example, if your recurring debt payments are $1,200 a month for a mortgage (or rent), another $150 a month for an auto loan, $250 a month minimum for credit cards, and $300 for student loans, the monthly debt payments are $1,900. ($1,200 + $150 + $250 + $300 = $1,900.)
If gross monthly income is $5,000, then the debt-to-income ratio is 38 percent ($1,900/$5,000 = 0.38 X 100 = 38%).
Debt to Income Guidelines
In general, underwriting for a conventional mortgage loan needs a DTI ratio “qualifying ratio of 28/36,” and FHA loans are less strict, requiring a 29/41 ratio.
The first number is the maximum DTI that can go to the housing (mortgage principal, interest, mortgage and hazard insurance, property taxes and homeowners dues). The second number is the maximum DTI for housing costs and other recurring debt.
Acceptable vs. Maximum DTI
To keep your debt-to-income ratio in the lender’s acceptable range and avoid higher interest rates, for example, financial planners and credit counselors would likely recommend:
Consumer debt: < 20% of net income
The credit agency Clearpoint provides the following guidelines for the consumer DTI ratio excluding housing costs.
Tier 1 – 15% or lessYou will likely have enough remaining income for all normal living expenses including housing, food, transportation, clothing, etc. If something unexpected happened and you were forced to take on more debt, you would probably be fine, having kept debt at a manageable 15% or less.
Tier 2 – 15-20%At this DTI level, most consumers are okay, but getting uncomfortable. It would be beneficial to consider a debt payoff plan like the Debt Snowball or Avalanche method. Self-evaluation is needed on how this level ever came about. Is it due to an unforeseen emergency or medical expense, or are you living above your means?
Tier 3 – 20%+Clearpoint characterizes this level as “the most dangerous” and ”something isn’t quite right.” You have more debt than you can afford and need to take immediate action to correct it.
Mortgage and Housing Expenses
The DTI changes significantly when mortgage and housing expenses are included and should remain below these levels:
- Housing debt: < 28% of gross income
- Total debt: < 36% of gross income
Not so coincidently, lenders prefer to see a debt-to-income ratio of less than 36%, with no more than 28% of that debt going towards the mortgage.
Did you calculate your debt-to-income ratios and compare them to these guidelines? How do you compare?
Interests are not Always Aligned
Remember, these are the guidelines used by lenders. Not surprisingly, they want to lend you money. But, your interest is to increase Net Worth. So, the lender’s interests are not necessarily aligned with yours.
If you fall below the guidelines, that’s a great start. But let’s take a closer look at the type of debt you have, and how it can impact your Net Worth over the long-term.
The aggregate U.S. DTI grew from 63% in 1980 to 96% during the third quarter of 2017. Lenders make money on loans not on improving your financial health or Net Worth.
Prudent Debt and Bad Debt
You may have read or heard about “good debt and bad debt.” I have a sufficient bias against debt, generally that it prevents me from using the word “good” to describe any type of debt (and I do use debt).
It may go too far to call “good debt” an oxymoron, but “good” is too generous.
Prudent debt rings truer, where prudent means: the careful or wise handling of practical matters; exercising good judgment or common sense.
Prudent Debt
Prudent debt, in some way, positively contributes to your financial future. It has an anticipated return that more than offsets the cost of the debt incurred. Examples of prudent debt are student loans, home mortgages, and business loans.
Student Loans
In our Exceptional Long Term Investment article, you saw an associate or bachelor degree provides an average 15% return per year for life on the cost of higher education, and that included the cost of the average student loan.
The bachelor’s degree recipient earns $1 million more, and an associate’s degree makes about $325,000 more than high school graduates over their life.
Home Mortgage
A home, like education, is an appreciating asset that increases in value over time. You can free up capital for higher return opportunities by taking advantage of low fixed-interest-rate mortgages available on very favorable terms.
Articles give mixed signals on the economics of home ownership vs. renting. This is understandable because there are a lot of variables to consider. For our purposes, here we’ll include home mortgage’s in “prudent debt.”
Business Loan
Businesses are cash flow generating asset and, similar to education, can produce positive returns above the cost of the company. Debt for business loans can positively contribute to your financial future.
Bad Debt
Pretty much all other debt is bad. Bad debt in some way negatively contributes to your financial future.
However, I can’t speak with a lot of experience about debt because I’ve avoided it “at all costs.” So, let us turn to someone that can, someone who went bankrupt.
Dave Ramsey did business as Ramsey Investments, Inc. and built a rental real estate portfolio worth more than $4 million four years after graduating from college. A larger bank bought his lender and demanded immediate repayment on the loans. He had to file for bankruptcy.
Ramsey eventually recovered financially, attended workshops and seminars on consumer financial problems, and developed a set of lessons and materials based partially on his own experience and partly on works and teachings of others. He went on to write five NY Times bestseller books including Financial Peace and The Total Money Makeover.
The Total Money Makeovers a straight forward book that gets to the usual root cause of money problems: our behavior.
“The decision to go into debt alters the course and condition of your life. You no longer own it. You are owned.” – Dave Ramsey
First Things First
If you are charging purchases because you can’t afford to pay with cash or pay off the credit card each month, you are spending more than you earn and living beyond your means.
I don’t have to tell you this is unsustainable, and you will face severe consequences. It may seem to be a solution at first, but it only makes matters worse and is painful to fix. Use your debt-to-income ratio as an early warning signal before it gets too far.
The One Good Thing About Bad Debt
In Welcome to the Journey, we wrote that this journey is “simple but not easy because you will likely also need to change yourself, those around you, and how you think about money.”
Think of bad debt simply as your current circumstance and starting point. What matters now is your response to this challenge. Rather than beat yourself up for getting into debt, consider it a valuable lesson learned and make the most of it.
You pay 17% to 24% interest on the balance if you carry credit card debt from month to month. Every payment that reduces your credit card balance saves you 17% to 24% on that balance. That’s a guaranteed 17% to 24% return to you rather than the finance company.
That’s the one good thing!
What We Learned Today
People with debt will tell you, as if you didn’t already know, how debt is a real obstacle to a happy and fulfilled life.
- Use the debt-to-income ratio to see where you stand and as an early warning signal.
- Debt is a loss of freedom; you voluntarily make yourself a slave to a lender and “financial” master.
- It limits future options as you willingly give up control over (what was) your money and future.
- Debt creates a positive return for the lender and a negative return for the borrower. Interests are not aligned.
- Compounding as shown [here] is **the eighth wonder of the world.** It can create millionaires out of ordinary people.
- Compounding is also a two-edged sword and can work against you to make millionaires of others with (what was) your money.
- Invert the problem by making credit card debt an investment. Pay down the balance and earn that 17% to 24% guaranteed return for yourself, not the lender.
The important thing is to recognize a problem so you can fix it. In the next article, we discuss practical ways to fix the bad debt that really work.
Debt Part 1 – Debt and Emergency Funds