The main reason I first started Consumerism Commentary was to publicly track my financial progress from “down-and-out” to “not quite as bad.” I started plugging my financial details into Quicken, and like Kara from Ka-Blog says, watching your net worth grow is addictive. There’s more to your finances than just the bottom line, though. I wasn’t aware of this until I started working in financial reporting and studied finance for my master’s degree.
I’ve mentioned financial ratios before. Last time I evaluated my finances using the working capital ratio, which gives me a picture of how well I’ll be able to handle my debt. First, I calculated my working capital ratio for the current month, then went back several months to determine a trend.
Now I’m going to calculate my debt to income ratio. This is another way of determining the health of my level of debt, but rather than comparing that total current debt with my liquid assets, I evaluate my income against my total debt payments (or debt service).
The debt to income ratio is popular in the world of personal finance, and if you ever apply for a mortgage loan, chances are the banks will want to know whether the added debt will require too much of your income.
I first calculated my debt to income ratio for 2006, taking into account the full payments made to my debt, which includes only a car loan and a student loan. Last year I made extra payments to my student loan on several occasions thanks to reimbursement from my company, so those payments are included.
I don’t include my credit card in the calculations because I don’t carry any debt month to month. If I had a credit card balance to pay off over time, I would include my monthly credit card payments in the calculation. The final result for my 2006 debt to income ratio is 0.25 (or 25%).
So is this good compared to the rest of the world? Here’s a guide from U.S. News and World Report:
36% or less: This is a healthy debt load to carry for most people.
37%-42%: Not bad, but start paring debt now before you get in real trouble.
43%-49%: Financial difficulties are probably imminent unless you take immediate action.
50% or more: Get professional help to aggressively reduce debt.
My ratio of 0.25 reflects the average over the entire year. The real test of measuring debt to income is whether the ratio improves over time. I can predict 2007’s debt to income ratio based on the sum of remaining payments due on my car loan, the sum of my expected monthly minimum payments to my student loans during 2007. I’m also using my January income multiplied by 12 to predict my 2007 income. (If this is how 2007 plays out, I’ll be quite satisfied.)
My debt to income ratio will go from 0.25 in 2006 to 0.04 in 2007, assuming I don’t add any debt such as a mortgage.
According to Janet Wickell, the projected ratio puts me in a good position to afford a mortgage, if I were interested. If a lender typically allows 28% of income to be used for housing expenses and 36% of income to be used for housing expenses plus any other debt, I have some wiggle room, again, assuming January proves to be representative of the rest of the year.
Updated December 20, 2011 and originally published February 7, 2007.