I’ve been in finance a long time and I do not believe debt is a bad thing. Debt is a powerful tool if used correctly and in moderation. If someone hands you a chainsaw, you’re going to want to learn how to use it first before turning it on because someone can get hurt. Debt is the same.
The average American household has $15,800 (Federal Reserve, Joint Economic Committee, Sallie Mae, TransUnion, 2012) of credit card debt. In the worst credit card debt cities in America, the average household owes 13-15% of its pre-tax income to credit card companies (Forbes), which means if you make pre-tax $100,000/year, you have total credit card debt of about $14,000.
Now, let’s get on with the math. We’re going to calculate a “debt-to-income” ratio (DTI). You can do a DTI ratio on all debt (we’ll do that first) and then a DTI on “bad” debt, which I define as debt that has an interest rate above 7% (I’m being really conservative here, some people say 10%).
DTI Good and Bad Debt (Monthly numbers)
Mortgage payment (w/o insurance & tax. If you pay rent, put your rent payment in) $2000
Car loan $0
Student loans $500
Credit card minimum payments (if you don’t know this, take 2% of total balance) $400
Appliance, specialty, family or other debt (includes child support or alimony) $0
Total $2900
Monthly Pre-tax income (all income including rents, bonuses, salaries) $9000
DTI = $2900/$9000 = .32 * 100 = 32%
0 -36% = Healthy DTI
37-42% = Not bad, but you should be trying to cut your debt
42 – 49% = You could be in trouble financial and soon! Start cutting now!
DTI Bad debt only – this can help you figure out if your credit card debt alone is high,include all debt with an interest rate above 7% (include credit cards that change to a higher rate after a few months)
Bad Debt DTI (Monthly numbers)
Car loan (if above 7%) $0
Credit card minimum payments (if you don’t know this, take 2% of total balance) $400
Appliance, specialty, family or other debt (not child support or alimony) $0
Total $400
Monthly Pre-tax income (all income including rents, bonuses, salaries) $9000
DTI = $400/$9000 = .04 * 100 = 4%
0 -10% = Healthy DTI
10-15% = Not bad, but you should be trying to cut your debt
+ 15% = You could be in trouble financial and soon! Start cutting now!