How do you know when you have too much debt?
One way you may know is that you are struggling to pay your bills. Or, you may feel so much stress about the debt you are carrying that it is keeping you up at night. Another way is calculating your debt-to-income ratio. This simple calculation tells you how much of your gross income goes to debt payments.
The debt-to-income ratio provides guidelines for how much debt you can afford based on your income. The guidelines are different depending on whether you rent or own your home. Though your house payment is technically a debt, you are building wealth through the ownership of your home. Renting a house or an apartment provides shelter for you and your family, but does not build equity or wealth.
So, what are the guideliness?
If you rent, you should spend no more than 20 percent of your gross income on debt.
If you own your home, you should spend no more than 36 percent of your gross income on debt.
Spending more than these limits means you may not have enough money left over to pay for everything else. Everything else includes:
- Income tax
- Social Security tax
- FICA
- Food
- Rent (if you don’t own your home)
- Electricity
- Gas
- Water and sewage
- Insurance—life, home, renter’s, auto, and health
- Gasoline for your car
- Car repairs
- Clothing
- Television, Internet, phone, cell phone
- Savings
- Pet food
- Prescription medicine
- Going out to dinner
- And so on
Use the debt-to-income ratio to keep your debt at manageable levels. The lower your debt-to-income ratio is, the more flexibility you will have and the more money you will have for everything else.
If you find your debt-to-income ratio is above the recommended guidelines, make a plan to reduce your debt. This starts with an understanding of what you owe.