Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
The term “consumer debt” refers to all types of non-mortgage debt obligations. Examples include outstanding balances on credit cards, installment loans for cars and other “big ticket” items (e.g., furniture and appliances), and student loans. For every person with outstanding consumer debt, there comes a point, called “enough,” where carrying too much debt starts to cause financial stress. Even minimum required payments become difficult to make or perhaps some payments get skipped entirely because debt obligations exceed your capacity to repay them.
How do you know when you’ve reached that point called “enough”? You know you have too much consumer debt when the following things start to happen:
¨ you put off paying bills because you’re worried you won’t have enough money to cover your debts (or vice versa) ¨ you juggle bills each month just to get by ¨ you use credit cards as your only means to buy necessities such as food and gas ¨ you get a cash advance from one credit card to make a payment on another card ¨ you avoid answering the phone because of frequent calls by bill collectors.
These are only a few signs that you have a problem with too much debt. More information can be found in the fact sheet Danger Signals of Excessive Debt. There is also another way to determine if your consumer debt obligations are out of line for your income: the consumer debt-to-income ratio. This ratio will tell you, with one number, whether you’ve taken on more debt than you can handle.
To calculate your consumer debt-to-income ratio, add up the total of your monthly consumer debt payments. Don’t include your mortgage or rent, utilities, or taxes in this calculation. Do include monthly payments for all of your consumer debts such as credit card payments, car loans, student loans, and even loans from family members who are being repaid monthly. Then determine your monthly after-tax (net) income. Don’t include overtime or bonus pay unless this income is guaranteed and regular. If you work for an employer, your paycheck stub will have this information. If you are self-employed, review your most recently filed Schedule C tax form and/or business income records from the past few months.
Divide your monthly consumer debt payments by your total net monthly income. The result is your consumer debt-to-income ratio. For example, if your total monthly credit payments add up to $450 (say a $275 car loan and $175 of payments on three credit cards) and your total monthly after-tax income is $2,800, your consumer debt-to-income ratio would be calculated as 450 divided by 2,800 = .1607 or about 16%. This means that 16% of your take-home income is being spent on debt repayment.
How do you interpret your consumer-debt-to-income ratio? It’s simple: the lower the ratio number, the better. If your consumer debt-to-income ratio is 15 percent or less, you’re probably in good shape credit-wise and can handle your monthly debt payments. A ratio of 10% is even better, especially when you have large monthly bills such as a high mortgage payment or expenses for child care.
If your ratio is 15 to 20 percent, you may start to experience financial difficulty. Simply put, too much of your paycheck is going toward yesterday’s spending. A consumer debt-to-income ratio of 20% is considered a “danger zone.” It means that one-fifth of your take-home pay is already “spoken for.”
My Personal/Household Consumer Debt-to-Income Ratio
1. My/Our Take-Home (Net) Pay $ ____________________
2. My/Our Consumer Debt Obligations:
(List the name of each consumer debt and the amount outstanding)
Example: XYZ Visa Card; $800
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
_____________________________ $ _______________
Total of Monthly Consumer Debt Payments $ ____________________
3. My/Our Consumer Debt-to-Income Ratio
(Divide Step #2 by Step #1)
Example: $350 ÷ $2,500 = .14 or 14% ___________________ %
If your consumer debt-to-income ratio reaches 30 percent, or higher, you have way too much debt. You will need to drastically curtail spending and should probably see a credit counselor. With so much of your after-tax income earmarked for debt payments, there isn’t much left for other expenses.
Now that you know the basics, it’s time to apply them. Use the worksheet below to calculate your personal or household consumer debt-to-income ratio: