Do You Have Too Much Debt?

Millennials love debt. We have a lot of it, and we can’t stop acquiring more. Our largest source of debt as a generation is credit card debt, which few people realize. On average, each of us has $33k in student loan debt. We may have an auto loan, and we’ve probably just purchased or are considering purchasing our first home and taking on a mortgage. Even though we turn to debt to reach all of our life goals, few of us actually know how much debt we have, and even fewer of us know how much of our income goes toward paying for our debts. But it’s important to know these things because having too much debt is risky and expensive. If used properly, debt can help you build wealth, but if used improperly it can devastate your finances. So how can you tell if you have too much debt?

A Little Bit About Debt

Debt is an amazing tool for wealth building. It allows you to purchase things that would otherwise take you a lifetime to save for, like a house. When debt is used to purchase things that appreciate in value or go up in price over time, it can build great wealth. Debt can also get you into a lot of financial trouble though. That’s because debt is a financial obligation. That means that you have to pay it back no matter what. Lose your job? Like the honey badger, debt don’t give a f**k. When in a bind, you can cancel other things like Netflix or your gym membership, but you still have to figure out how to make all of your debt payments. The more of your income that goes to pay for your debts each month, the more vulnerable you are to getting yourself into financial trouble that leaves you unable to make your payments. If you can’t make your payments, you could default on your loan. If you default on your loan, your credit score will drop dramatically, any collateral backing your loan like your car or house will be seized by the bank, and in the worst-case, you will have to declare bankruptcy. To avoid ending up in one of these scenarios, it is important to know how much debt you have, and how much of your income goes toward your debt payments. The best metric to determine if you have a healthy debt amount is the debt to income ratio (DTI).

How to Figure Out Your Debt to Income Ratio

The best way to determine if you’re over-leveraged, aka have too much debt, is to calculate your DTI. This is a good ratio for you to know to understand how much of your income goes toward paying off your debt, but it’s also good to know because this ratio is used by banks and lenders to see if you qualify for a loan. Lenders will often use your gross DTI when you are applying for a loan, but your net DTI gives you a clearer understanding of how much of each paycheck goes to debt payments. We will discuss the importance of each, and how to calculate them below.

Calculating Gross DTI

To calculate your gross DTI, you first need to calculate your total minimum monthly debt payment. To do this, list out all of the debt you have, and what your minimum monthly payment is for each loan. This will include your student loans, car loans, mortgage, personal loans, etc. You want to list the minimum payment because this is what you are required to pay. If you are paying extra each month (good job!) and get into financial trouble, you can always cut back your payment to the minimum amount required. If you’re married, I suggest you include both partners’ debts. If you have credit card balances that will not be paid off in full on your next payment, you also should include the minimum payment for those. Once you have all of your loans and minimum monthly payments listed, add them up to get your total minimum monthly debt payment. Below is an example of how Patricia calculated her minimum monthly debt payment.

Patricia’s Monthly Debt

• Student Loans – $250
• Car Loan – $300
• Mortgage – $1,000

Total minimum monthly debt payment

           $250 + $300 + $1,000 = $1,550

Now that you know your total minimum monthly debt payment, you need to calculate your monthly gross income or your before-tax earnings. This is your quoted salary, not your take-home salary. If your company quotes your salary as $50k/year, that is your gross income. Divide your salary by 12 to get your monthly gross income. If you have income from other sources like freelance work, include that as well. For variable income, you should look back at your earnings over the last 6-12 months and take a monthly average. If your pay varies because you are paid hourly, you can find your year to date (YTD) gross earnings on your pay stub. Divide that by the number of paychecks you’ve received YTD to get your average gross income per pay period, then multiply that by the number of times you’re paid in a full year and divide that by 12. Again, if you’re married, include both partners’ incomes. Once you have listed all of your income sources and the monthly income they generate, add them up to get your total monthly gross income. Patricia’s example is continued below.

Patricia’s Monthly Income

• Annual salary from job – $50k
  • Monthly – $50k/12 months = $4,167
• Freelance photography income – $200/month

Total monthly income

$4,167 + $200 = $4,367

With both components of your gross DTI calculated, you can now divide your total minimum monthly debt payment by your monthly gross income to get your gross DTI. Our example continues below.

Gross DTI = total minimum monthly debt payment/monthly gross income

Patricia’s Gross DTI

• Total minimum monthly debt payment – $1,550
• Total monthly gross income – $4,367

Gross DTI ratio – $1,550/$4,367 = 35.5%

So what does your ratio tell you? The lower your ratio, the better. A lower DTI means that you are more likely to be able to pay your debt obligations on time because less of your income is allocated to them. While debt is considered a financial obligation, people will pay for other necessary expenses like food and medicine before they pay their debt. If too much of your income goes toward paying for debt, you’re more likely to miss a payment if you run into any financial problems. Banks want to make sure you can pay them back, and this ratio is a great way for them to evaluate your ability to do that.

If you are looking to take out a mortgage, the highest gross DTI ratio the bank likes to lend to is 36%. That includes your future mortgage payment for the loan you’re seeking. Banks will often still approve you for a loan if your DTI is up to 43%, but they may add some additional provisions to the loan. If your DTI is higher than 43%, the risk of lending to you is high. In this scenario, you will often only be offered a subprime loan, which will carry a much higher interest rate. A subprime loan will end up costing you a lot more money in interest and increase your chances of defaulting on the loan. If your gross DTI is higher than 43%, it is better to pay down your other debt first, and then apply for a loan once your DTI has improved. Based on our example above, you can see that Patricia is just under the acceptable 36% DTI threshold.

Calculating Net DTI

Since your gross income is not your actual take-home pay, to determine how much of your spending money goes to pay off debt, you can calculate your net DTI. Banks won’t use this to determine if you qualify for a loan, but you should use it to determine your financial health and make future financial decisions. Again, the lower the ratio the better.

To calculate your net DTI, you will use the same minimum monthly debt payment amount you calculated earlier. We will continue with Patricia’s earlier example.

Patricia’s minimum monthly debt payment – $1,550

Next, you’ll need to calculate your net income. This is your take-home pay, not your quoted salary. It is the amount of money that is deposited into your bank account and that you can actually use to buy things. If you receive a salary from your employer, this is an easy number to calculate. Just look at the biweekly amount that is deposited into your account and multiply by 26, then divide by 12 to get your monthly take-home pay. If you have variable pay, you will need to take an average of your previous 6-12 month deposits. If you are self-employed or do contract work where taxes are not taken out before you’re paid, I would suggest using 50% of your gross income. Your net income is probably higher than that, but this is a good conservative estimate. Patricia’s monthly net income is calculated below.

Patricia’s Net Income

• Net income from salary – $1,250 biweekly
  • $1,250 x 26 / 12 = $2,708 monthly net income
• Freelance photography net income – 50% of $200 gross income
  • $200 x .5 = $100 net income

Total monthly net income

           $2,708 + $100 = $2,808

To calculate your net DTI, you will use the same formula we used earlier, but you will replace your monthly gross income with your monthly net income.

Net DTI = total minimum monthly debt payment/monthly net income

Patricia’s Net DTI

$1,550/$2,808 = 55%

Your net DTI will tell you what percentage of your monthly take-home pay is used to pay for your debt. Keep in mind that you also still need to eat, get gas, etc. to function, so you’ll need to earn more than your net DTI to survive, and meet your minimum payments. If you are married, evaluate how much of your income comes from each partner. If the higher earner loses their job, will you still be able to meet your obligations and eat? The higher your net DTI, the harder it will be to meet your basic needs and financial obligations if you hit financial difficulties.

What to Do with Your DTI Ratio

After calculating your gross and net DTI, you may find that you’re over-leveraged. If you’ve taken on too much debt, you can use a payment calculator like this one to figure out how much longer you have until you can pay off each loan. If some of your loans will be paid off in the next year, calculate your DTIs after those are paid off to see if you will be in a better position. If you still have a significant amount of time before you’ll pay off any of your loans, it is critical that you set up a payment plan and stick to it. If you’re really anxious about the amount of debt you have, start making larger monthly payments if you can. This will reduce the length of time it will take you to pay off your loan. Another option is to sell something that you have a collateralized loan on. However, this scenario isn’t usually helpful because most of millennials’ debt is in credit cards and student loans, not collateralized loans like mortgages and car loans.  

If your DTI is in the healthy range, congrats! You can now feel some relief over your finances. If you haven’t bought a home but want to, you can use your DTI calculation to look at different mortgage payments and how they will affect your DTI. If you find that you can afford a mortgage payment of $1,500 and still maintain a healthy DTI, you can use that to figure out the highest home price you can afford. Knowing your DTI will allow you to keep making healthy financial decisions and build wealth in the future with less risk of defaulting on your loans.

Whether your DTI is in the healthy range, or higher than you expected, you now know one of the most critical components of your personal finances, your DTI ratio. Debt can be an amazing tool, but when trying to build the life we want, we can end up over leveraging and putting ourselves at risk. Continuing to track your DTI in the future will keep you financially healthy and allow you to use debt as a wealth-building tool and become a rich bitch.