Consumers' ideal debt range is linked to their income, current amount of debt, and future plans, which may include a home purchase. People have to determine for themselves whether they're carrying too much debt by taking an inventory of their monthly expenses and comparing those costs with the amount of income they earn each month. Generally, consumers can avoid financial problems if their debt payments take up less than 20 percent of their income.
Debt-to-Income Ratio
A Rutgers Cooperative Extension Service article titled "How Much Consumer Debt is Too Much?" recommends calculating your consumer debt-to-income ratio by dividing your monthly debt payments by your after-tax monthly income, which is your take-home pay. Multiply the resulting number by 100. The calculation shouldn't include mortgage, rent, utility or tax payments, but it should include things such as car and credit-card payments. Someone who has a monthly after-tax income of $2,500 and monthly bills that add up to $500 has a consumer debt-to-income ratio of 20 percent. Therefore, 20 percent of that person's take-home pay is being spent to pay debts.
Interpreting Debt Ratios
It's important to interpret what your consumer debt-to-income ratio means after you calculate it. According to the Rutgers Extension Service article, a ratio of 15 percent or less signifies good debt management and that a consumer likely can handle his monthly debt obligations. The article says a ratio of 20 percent should be considered a "danger zone" because one-fifth of a person's take-home pay is consistently consumed by debts each month. Remember that the ratio doesn't include your other expenses for housing, utilities, groceries, transportation and other everyday costs.
Front-End Ratio
A Bankrate.com article titled "Debt-to-Income Ratio Important as Credit Score" points to another consumer ratio that signifies people's ability to pay for their current home or to buy a new home. It's called the front-end ratio, and it's calculated by adding up the monthly principal paid on a mortgage, along with its interest, taxes and insurance costs. The resulting number should be divided by your pre-tax, or gross monthly income, and multiplied by 100. The Bankrate article indicates a consumer's home generally is considered affordable if the front-end ratio is not more than 28 percent.
Considerations
People who decide they need to reduce their debt ratios should document all of their expenses to determine where their money is going. Bankrate suggests examining expenses to find areas where you can cut costs. You should then take the money you save from cutting back and use it to pay down high interest debts, which usually includes credit cards. High-interest debts make it harder for people to reduce their monthly expenses and lower their debt ratios.
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