Monday, February 25, 2008

Do You Have Too Much Debt?

Leverage, or the use of debt financing, can provide the borrower with significant benefits when used properly. But is it possible to get to the point where you may be taking on more debt than you can handle? Obviously, there are the extreme cases where individuals finance their lifestyle to the point they overextend themselves and cannot meet their debt obligations. These cases usually result in something bad, including bankruptcy. But what about the "everyday" borrower that has a mortgage, car loan, student loan, and possibly a credit card with an outstanding balance. How much debt is too much debt?

Most lenders like to see that your debt payments do not take up more than 36% of your monthly gross income. They determine this ratio percentage by calculating your personal debt-to-income ratio. In general, a lender will consider you an increased risk of default if you are close to or exceed this 36% threshold.

So how do you calculate your own debt-to-income ratio? Let's use the following hypothetical example to illustrate how easy it is to determine if you have too much debt:

  1. Joe earns a gross annual salary of $82,000 per year or $6,833.33 per month.

  2. Joe has the following personal debt liabilities and associated monthly payments:

-- Home Mortgage $ 1,500
-- Student Loan $ 225
-- Auto Loan $ 350
-- Credit Card(s) $ 50

Total $2,125

To calculate Joe's debt-to-income ratio, we divide the total monthly debt & liability obligation payments by his monthly gross income as noted below:

Total Monthly Debt Payments/Monthly Gross Income or $2,125/$6,833.33 = 31.1%

The 36% threshold noted above is typically used by lenders as a rule of thumb threshold level. Some may require a ratio less than 36% and others may be more liberal and allow for a threshold greater than 36%. Either way, calculating your personal debt-to-income ratio will provide you with the answer to the question: Do I have to much debt?

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