Debt to Income Ratio: Not Just for Banks

What is a debt to income ratio? Simply put, it is generally a measure that lenders will use to determine whether it is safe to lend you more money.

But does it have any use outside of lending? Can we use it in our own households to assess our situation and if we are in debt, whether we can handle it ourselves or need to seek help like a debt consolidation loan?

debt to income ratio

The answers are Yes.

First we are going to need to modify the traditional debt to income ratio calculation. Most lenders use GROSS income to calculate this. I’m not sure why, since gross income does not take into account what we actually get to keep at the end of the month.

For this reason, it is safer to use our net income, or more specifically, our pay minus federal, state and local income taxes. This is the true number we have to use. In this calculation, you should add back any income you receive as a tax overpayment (refund), in order to be more accurate.

While it’s nice to pretend like we actually make more, it’s best to level with yourself and start thinking about your income as NET income.

Debt to Income Ratio in Real Life

So let’s look at a fictional family, the Joneses (because we like to pick on the Joneses). After taxes, their monthly take-home pay is $3,000. If we annualize this (multiply it by 12), they take home $36,000 per year. This puts them near the median household income in the US, which hovers around $50,000.

Before we move on, let’s take a look at some average or median consumer debt statistics (link temporarily disabled due to a warning on that site) for the United States:

  • Average credit card debt per household with credit card debt: $15,799
  • Average total debt in 2009 (including credit cards, mortgage, home equity, student loans and more) for U.S. households with credit card debt: $54,000. (That’s down from $93,850 in 2008.)
  • Average total debt in 2009 (including credit cards, mortgage, home equity, student loans and more) for all U.S. households: $16,046. (That’s down from $35,245 in 2008.)

 

Let’s take a look at the Joneses. Let’s say they have $15,000 in credit card debt, $25,000 in student loans, and $20,000 in car loans. That gives them a total consumer debt of $60,000, not too much above the average total debt of $54,000 for households with credit card debt (but we haven’t even taken into account their mortgage).

Now let’s figure out their REAL debt to income ratio, using their take home pay. We will use the formula (Total Debt/Take Home Income = REAL Debt to Income Ratio).

So, $60,000/$36,000 = 1.666666… or 166%. That’s right, their consumer debt (not counting mortgage) is over one and a half times their yearly income. Needless to say, paying off this debt is going to be very tough for this family.

I think many of us have been in this position before. Imagine if they had a boat or a motorcycle, adding another $20,000 to their debt. I think many of us know people who fall into this range as well.

Should We Panic?

As I mentioned before, figuring out your true debt to income ratio is an exercise to see whether you can pay off your debts yourself. I honestly believe that a family with a stable income, even if they owe up to 200% of their income, can get out of debt with diligence. Sure it’s going to take a few years of sacrifice, and some things will need to be sold off, but it can be done.

Though I abhor all consumer debt, not everyone feels that way. If you are at 10% or lower debt to income ratio, you are probably okay and can easily turn your situation around if you want. If you are at 25%, it’s probably time to enact a plan to get out of debt.

But imagine a family with 300, 400, or even 500% debt to income ratio. This family likely experienced a sharp drop in income through a job loss, or some crushing medical bills.

These families will likely need help like debt consolidation or even bankruptcy. They face immediate concerns like repossession, foreclosure and homelessness. Keeping their family together and sane should be their first priority.

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22 Comments
  1. I never realized you were supposed to calculate that based off of net income. I’m pretty sure I don’t want to know what mine is. :)

    I’m shocked that the average debt (including mortgages) is only $50k. If my numbers are right that’s only 5 trillion dollars of total debt or so, right?

    I think the last time I looked (it’s been about a year) the total debt for consumers was $16 trillion (including mortgages).

    Sorry…not trying to argue, that number stood out to me and it’s just really hard to fathom.
    Jason @ WSL recently posted..Broke, Desperate, and Being an IdiotMy Profile

    • I wonder if a bunch of debt was erased from the books after 2008? It looks like it did almost cut in half from 2008 to 2009. Yeah, there were some statistics that were surprising on that page if you click through.

      • I forgot to mention that using net is probably not the way most people do it, especially banks, but I feel it gives a more realistic picture of what you can actually afford. Since we know a certain percentage is earmarked for the government, I think we are best just leveling with ourselves and taking it out of the equation.

  2. John,
    The numbers you shared above seem pretty interesting. I for some reason thought they’d be higher, but than again the population of US is 350+ million. In Canada, late in 2011 they talked heavily about the debt to income ratio, and basically at one point the average person owed $1.50 for every $1 they earned. The ratio is lower today, but I remember banks tightening their belts during that point. Great topic though!
    Eddie recently posted..Making the Most of a Gap YearMy Profile

  3. I don’t know how useful this really is. I think there’s a big difference between having secured and unsecured debt and your assets really matter, too, not just income. For instance, my family has a debt-to-income ratio the way you’ve calculated it of 34%. But we have the assets set aside to pay off this debt when we want to. I’m probably going to have to be comfortable with a debt-to-income ratio of 3-1 or more right when we buy a house in an expensive area. I don’t think that makes home ownership anything to panic about.

    I’m with Jason – are you sure those debt figures include mortgages? They seem really low. Did you look at multiple sources?
    Emily @ evolvingPF recently posted..Joint and Separate Money Series: Odds and EndsMy Profile

    • My efforts here are focused on consumer debt and the fictional example doesn’t take into account their mortgage. I am working on some ways to look at consumer debt + mortgage debt and seeing what the danger zones would be for that, but that would be for a later post.

      I agree that mortgage debt is “different,” which is why I didn’t address it too much.

      The numbers look low depending on how they are measured. For example, if you figure the average credit card debt for ALL Americans, it’s going to be lower than if you just figured the average for just households that have a credit card. Similarly with TOTAL debt. Many people are so poor that no one will loan them a dollar. These people bring the average debt for all households down.

      I copied the stats verbatim from the source, and have seen them corroborated in multiple places. They are what they say they are.

      That being said, I’m not a statistician. If you have different numbers, please point me to them in case I need to update my stats. It’s tough finding timely numbers because most data is reported in the aggregate.

      I am sorry Emily that you did not find this post useful, but I did not write it with the idea that everyone would find it useful.

      You are fortunate to have more assets than debt. Many people aren’t so lucky. They can’t just wake up one day and decide to make the debt go away. You also have a differing debt tolerance than I.

      Can we agree to disagree?

      http://www.statisticbrain.com/credit-card-debt-statistics/

      • If you are just looking at unsecured debt in this calculation, I agree with you that a debt-to-income ratio of several times is very worrying – as long as there are no assets that can be liquidated. I guess I misread or misinterpreted your post to be more broad than it was intended. And even if we do disagree, of course that is OK! I like having a critical back-and-forth over ideas – I think we both benefit from the exchange.
        Emily @ evolvingPF recently posted..Joint and Separate Money Series: Odds and EndsMy Profile

  4. For this kind of calculation I’d be tempted to ignore a mortgage debt since that is going to build a valuable asset. Debts like credit cards and loans are much more important to pay off quickly.
    Modest Money recently posted..Planwise Financial Planning SoftwareMy Profile

    • I agree, and in fact my calculation ignores the Joneses mortgage. Mortgage debt is “different” and I wouldn’t stand on a mountaintop and tell everyone they should pay their homes off ASAP.

      Thanks for reading.

  5. I don’t have a mortgage, so thankfully my total debt is well below 50% of my take-home pay =) and it goes down every month!
    Bridget recently posted..Giving as an integral part of personal financeMy Profile

  6. My debt to net income ratio is over 500%. At least my largest debt is a mortgage and not something like credit cards. But maybe I should start to focus more on debt repayment and de-leveraging, rather than aggressive investing like I’ve been doing all this time. It’ll take some time to get back to a stable level, but I better do it now before interest rates go up.
    Liquid recently posted..Keyword Searches – May 21stMy Profile

  7. This makes me feel more comfortable with my ratio of 25% but holy cow how excited will I be when that goes to zero!
    Frugal Portland recently posted..Getting out of debt is boringMy Profile

  8. It is important that people keep an eye on their debt to income ratio! It’s a great guide for what your debt level is (and if it needs to be lowered) as well as a way to see what lenders see when looking at your financial profile. However, I never thought about the fact that we always look at the gross and not the net! What a difference this really does make!
    Shannon-ReadyForZero recently posted..Announcing the ReadyForZero iPhone App!My Profile

  9. This is a critical part of the “net worth” line people should draw as they begin the planning process. Although it’s tough for some people to look at, it’s always empowering when you look the devil in the eye and realize that you, too, can get out of debt.
    AverageJoe recently posted..In Defense of Financial Advisor FeesMy Profile

  10. Reading this post made me look at our financial situation. Good thing is that we have a relatively manageable debt to income ratio.
    Samantha recently posted..disneyland ticketsMy Profile

  11. Super timely post – we are looking at which metrics are critical to help people understand whether they are financially healthy or not. I’d love to connect to understand other financial metrics that are important. We are starting to build these into our software to help people be aware of their finances and in turn make better decisions
    Vincent Turner (@vinaeco) recently posted..Planwise Plugin – Tools for sites & blogsMy Profile

    • That sounds like an excellent feature, Vincent. I’ve actually been thinking about this for a few months and would be happy to share my ideas. Please contact me through my Contact page on the left sidebar. Thanks!

  12. I enjoyed the article and all the comments, most comments are relevant all probably best to take an holistic view and not focus on which is the ideal as my guess is there is not one.

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