Most lending agencies view the amount of total debt carried as a measure of financial strength. Some debt is essential and, if used correctly, can even improve finances. If debt is structured to build assets or provide more quality of life, it may worth taking on. On the other hand, buying consumables on credit without paying the charges back will usually only hurt finances. While most people are aware they need to carry some debt, calculating the total ratio of good to bad debt may enable them to make better financial choices in the future.
Add up all forms of debt, including interest owed, to arrive at a total figure. This means gathering all loan commitments and other types of consumable debt. Other types of debt include credit card obligations, car loans and lease payments, as well as store charge cards or gas cards. It may not be necessary to include mortgage or rent when totaling debt obligations, as these amounts are not usually counted as bad debt by lenders.
Calculate total income by adding take-home pay, bonuses and commissions. Include any income from real estate, investments or net business profits. Deduct any expenses, fees or taxes owed to find the total net income amount.
Divide the net income amount by the total amount of consumable debt to find the debt-to-income ratio. This ratio represents the percentage of net income that is paid towards consumable debt. The higher the percentage, the more a situation is viewed as susceptible to an inability to meet financial responsibilities. For instance, if a emergency comes up, such as an unexpected medical bill or loss of employment, the more difficult it could be to pay all obligations.
Compare the debt-to-income ratio to a standard to determine what actions might need to be taken. This number should be as low as possible, but no more than 10 to 15 percent, to indicate good financial strength. If the ratio is between 15 and 20 percent, this might represent the start of a financial problem. If a person's debt-to-income ratio reaches 25 percent or higher, they may become an unlikely candidate to receive any more loans.
If possible, build up a cash reserve for emergency situations. Usually a reserve amount equal to 3 to 6 months of income is a good target, but even more is better. An emergency fund provides protection for unexpected financial crisis and helps indicate financial strength to many creditors and loan officers.
A high debt-to-income ratio can show there are no additional funds available for savings and investments, due to the fact that a large portion of the income is being used for paying off consumer debt.
- "Personal Finance At Your Fingertips"; Ken Little; 2007
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