Most people have some kind of debt. It might be in the form of a mortgage, an auto loan, a student loan, or even a credit card balance. Having debt isn’t a bad thing as long as you are taking steps to pay it off. It’s having too much debt that can cause an unhealthy financial life. Taking the time to determine whether or not you have too much debt can provide confirmation that you are doing things right or the realization that some financial changes are needed.
One of the best ways to calculate your debt load is by figuring out your debt-to-income ratio. This is the amount of debt you have relative to your income. You can calculate your debt-to-income ratio including good and bad debt, or you can leave out good debt. If you want to gauge your debt overload, it’s typically better to calculate the ratio considering only bad debt.
On the other hand, if you want a total picture of your debt, include both good and bad debt (see Good Debt vs. Bad Debt).
Calculating Debt Overload
For starters, let’s say you want to gauge just your debt overload. The calculation for your debt-to-income ratio is fairly straightforward. Simply add up the amount you spend each month on bad debt and divide it by your total monthly income. Multiply that number by 100 to come up with a percentage. The result is your debt-to-income ratio.
For example, let’s assume you make $3,000 a month. Let’s also assume you spend $300 on credit card payments and $450 on an auto loan. Your ratio calculation would be $750 divided by $3,000 which is equal to 0.25. Multiply that by 100 for a debt-income-ratio of 25%. In this example, you spend a quarter of your income on bad debt.
When it comes to debt, whether good or bad, the lower the debt you have, the better. A bad debt ratio beyond 10% is too high and often is a sign that you are overloaded with debt. Under this scenario, you would have too much bad debt.
Understanding Your Total Debt
There will be times when you want to evaluate your total debt picture, including both good debt and bad debt. The calculation is the same as in the previous example; the only difference is that you will include all your debt rather than just bad debt.
To calculate your total debt-to-income ratio, add up your total monthly debt expenses. This includes payments for credit cards, student loans, mortgage or rent, child support or alimony, and other loans or credit cards.
Next total your monthly income, including take-home pay, alimony or child support, bonuses, or dividends.
Divide your total debt payments by your total income (don’t forget to multiply by 100) for your debt-to-income ratio.
Your total debt-to-income ratio, considering both good and bad debt, is best at 36% or lower. A ratio lower than 30% is excellent, while a ratio over 40% is a red flag for a potential financial disaster.
The Result
If you determine that you have too much debt, Reducing Debt can help you put together a plan to lower your debt, making it easier to manage.
http://credit.about.com/od/reducingdebt/a/toomuchdebt.htm
