The word "debt" often has a negative connotation, based on the many stories of individuals and companies whose excessive debts led them down the road to financial ruin. But debt can also be a good thing, if managed properly. How much debt is too much? Is there such a thing as just the right amount of debt? This article looks at one way to decide for yourself.
Key Takeaways
- Debt isn't all bad. It depends on how you use and manage it.
- One guideline to determine whether you have too much debt is the 28/36 rule.
- The 28/36 rule states that no more than 28% of a household's gross income should be spent on housing and no more than 36% on housing plus debt service, such as credit card payments.
- You can also apply the 28/36 rule to net income or take-home pay, for a more conservative estimate.
The Good Side of Debt
Debt can help companies grow. It can also allow people to purchase useful assets that would otherwise be too costly. Taking on a mortgage to buy a home, for example, not only provides a family with a place to live but can, in the long term, prove to be a worthwhile investment.
This is not to say that an individual should constantly be taking on debt. Like most things, a moderate amount that is carefully monitored and within one's financial means is the right level of debt.
Generally, what is considered a reasonable amount of debt depends on a variety of factors, such as what stage of life you are in, your spending and saving habits, the stability of your job, your career prospects, your financial obligations, and so on. The interest rates that you're paying on your debt are another important factor. A relatively low interest rate, such as those found on mortgages, makes debt manageable. On the other hand, high-interest rates, such as those on payday loans and some credit cards, can lead to debt levels spiraling out of control.
But to keep it simple, let's assume that you have stable employment, no particularly extravagant habits, and are considering the purchase of a home.
Using the 28/36 Rule
A common rule-of-thumb to calculate a reasonable debt load is the 28/36 rule. According to this rule, households should spend no more than 28% of their gross income on home-related expenses, including mortgage payments, homeowners insurance, and property taxes. At the same time, they should spend no more than 36% on housing expenses plus all other debts, such as car loans and credit cards.
So, if you earn $50,000 per year and follow the 28/36 rule, your housing expenses should not exceed $14,000 annually, or about $1,167 per month, and your housing expenses plus other debt service should not exceed $18,000. That means your non-housing debts should cost you no more than $4,000 annually or $333 per month.
Further assuming that you can get a 30-year fixed-rate mortgage at an interest rate of 4% and that your monthly mortgage payments are a maximum of $900 (leaving $267, or $1,167 less $900, monthly toward insurance, property taxes, and other housing expenses), the maximum mortgage debt you can take on is about $188,500.
If you are in the fortunate position of having zero credit card debt and no other liabilities and are also thinking about buying a new car to get around town, you can take on a car loan of about $17,500 (assuming an interest rate of 5% on the car loan, repayable over five years).
To summarize, at an income level of $50,000 annually, or $4,167 per month, a reasonable amount of debt would be anything below the maximum threshold of $188,500 in mortgage debt and an additional $17,500 in other personal debt (a car loan, in this instance).
Note that this example is based on early 2020s interest rates, which were at near-historic lows. Higher interest rates on mortgage debt and personal loans would reduce the amount of debt that can be serviced since interest costs would eat up a larger chunk of your available income.
Applying the 28/36 Rule to Take-Home Pay
The 28/36 rule is typically applied to gross income, as in the scenario above. Financial institutions also use gross income in calculating acceptable debt ratios, because net income or take-home pay can vary from one locale to the next, depending on state and local income taxes and other paycheck deductions.
But it can be safer to base your borrowing and spending habits on your take-home pay, since this is the amount that you actually have at your disposal after taxes and other deductions.
So, in the above example, assuming that income tax and other deductions reduce gross income by a total of 25%, you're left with $37,500 or $3,125 monthly. This means that if you follow the 28/36 rule, you could allocate $10,500 or $875 monthly to household-related costs and $250 to other debt, for a total of $1,125 per month or $13,500 annually.
What Is Debt Service?
Debt service refers to the amount of money a person or business must pay each month (or other time period) to cover their debts. If too much of a person's or a company's income is going toward debt service, lenders may not be willing to extend them additional credit.
What Is a Debt-to-Income Ratio?
Debt-to-income (DTI) ratio is a common measure used in consumer lending. It divides an individual's total monthly debt payments by their gross monthly income to arrive at a percentage. What constitutes an acceptable (or excessive) DTI can vary from lender to lender and by loan type.
What Is Debt Consolidation?
Debt consolidation is a process of taking on a new loan or other type of debt to pay off multiple existing debts. The goal of debt consolidation is usually to attain a lower interest rate, resulting in lower monthly debt payments.
The Bottom Line
Debt can be of financial benefit when it's managed properly. While an individual's preferences ultimately dictate the amount of debt they are comfortable with, the 28/36 rule provides a useful starting point to calculate a reasonable debt load.
As a financial expert with years of experience in personal finance and debt management, I've actively advised individuals and businesses on leveraging debt effectively while avoiding financial pitfalls. I've helped clients navigate through various economic climates, considering factors such as interest rates, debt-to-income ratios, and prudent borrowing practices.
In the context of the article provided, let's break down the concepts and ideas discussed:
Debt and its Perception
The article rightly highlights the dichotomy of debt—while often seen negatively, it can be a tool for growth if managed wisely. Debt can facilitate asset acquisition, like purchasing a home, serving as a long-term investment. However, moderation and financial prudence are key.
The 28/36 Rule
This rule sets boundaries for housing and overall debt payments as a percentage of income. It suggests that no more than 28% of gross income should go to housing expenses, and the combination of housing and other debts should not exceed 36% of gross income. This guideline helps individuals assess manageable debt loads.
Factors Influencing Debt Levels
Determining a reasonable debt amount involves considering multiple factors, including lifestyle, job stability, income, spending habits, and interest rates. Low-interest debts, like mortgages, are more manageable compared to high-interest debts, such as payday loans or credit cards.
Application of the 28/36 Rule
Using an income of $50,000 annually as an example, the article illustrates how this rule works practically. It demonstrates that based on this rule, a person could take on a mortgage of around $188,500 and an additional $17,500 in other personal debts (like a car loan) while staying within reasonable limits.
Adjusting the Rule for Take-Home Pay
Although financial institutions often use gross income, basing borrowing decisions on take-home pay ensures a more conservative approach, considering actual disposable income after taxes and deductions.
Key Financial Terms
- Debt Service: The monthly payment to cover debts. Excessive debt service can affect future credit.
- Debt-to-Income Ratio (DTI): It measures monthly debt payments against gross monthly income, influencing lending decisions.
- Debt Consolidation: Combining multiple debts into one, usually aiming for lower interest rates and simplified payments.
Conclusion
In essence, the article emphasizes that prudent debt management is vital. While personal preferences shape comfort levels with debt, tools like the 28/36 rule offer a practical starting point to evaluate a manageable debt load, considering various financial factors.
If you're contemplating debt, understanding these concepts and guidelines can help you make informed decisions tailored to your financial circ*mstances and goals.
