The Debt Safety Ratio

People sometimes take on more debt than they can handle. There are several guidelines and tools available for calculating when you're getting close to your financial limit, and one of these tools is the debt safety ratio. This ratio is a method for calculating whether your debts, not counting your mortgage, are absorbing too much of your paycheck.

Debt Safety

The debt safety ratio compares your take-home pay with your monthly debt payments, John D. Martin of the Waddell and Reed financial consulting firm states in a brochure. The debts include credit-card bills, personal loans and installment payments, but not mortgage, insurance or utility expenses. Your income total should include the money you take out for voluntary deductions, such as health-savings accounts or 401k plans. Divide your debt by your pay to determine your debt safety ratio. For example, if you take home $1,200 a month and you pay $300 in credit-card bills, your ratio is 25 percent.

Interpretation

You're doing all right if your debt safety ratio is 20 percent or below, Franciscan University of Steubenville states in its website. It suggests trying to attain a debt safety ratio of 10 to 15 percent, or even less. Higher debt ratios limit your financial flexibility and make it more difficult to reduce expenses if you lose your job or have unanticipated expenses. The higher your debt ratio, the more important it is to find ways to manage your debts.

Debt Service Ratio

If you want a different perspective on your debt position, Martin recommends making a debt service ratio calculation as well. To determine the debt service ratio, you calculate your monthly debt, including your mortgage but not including any debts you expect to pay off within the next 10 months. Divide that figure by your pre-tax pay, instead of take-home pay. If the result is greater than 35 percent, you may have problems. Below 25 percent is considered a safe ratio.

History

Writing in "Financial Services Review" in 1996, Sue Greninger, Vickie Hampton, Karrol Kitt and Joseph Achacoso state that financial analysts used ratios to calculate the health of businesses long before they thought of applying them to families. Analysts began pointing out in the mid-1980 that they had no standard method for measuring a family's financial health. Later, writers began attempting to come up with ratios that would help assess family finances. Analysts have developed several formulas since then -- various ratios measuring debt, liquidity and inflation protection relative to income.