How do you know if your debt ratio is healthy? Let’s say you’re making a good salary, but you’ve got a big mortgage and car loan. Is there a point at which you’re tipping the scales and being weighed down with too much debt?
One way to gauge is by calculating your debt-to-income ratio. It’s easy. Add up your net monthly income and divide that by your monthly debt payments: mortgage, car payment, loans, credit cards. If you net $6,000 a month, and pay $1,500 to your mortgage, $300 to your car, and $200 in other debt payments, that equals $2000. Your debt ratio is 30%.
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What does that mean?
A debt ratio isn’t important in and of itself, says Galia Gichon, founder of Down-to-Earth Finance. But, it acts as a litmus test for more important questions: Does the amount of debt you carry enable you to put money aside for big financial goals like retirement and a safety fund?
Someone who carries a debt ratio of 20% to 30% is probably able to hit their savings goals. Forty percent is okay — but it probably means you’re not putting much aside. Gichon says she sees many people in the 50% range. “At that point, you’re probably paying your bills and your mortgage, but you’re not able to get ahead, once you take care of expenses.”
This is where you can toss the ratio aside and focus on what it’s pointing to: Do you have a savings problem? Is your debt impeding your ability to prep for the future?
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Solutions to the debit/savings issue obviously need to be tailored to the individual. In broad terms, you can make more money, you can get rid of debt, or you can get creative. On the more creative side, Gichon recently encouraged a client to consolidate her student loan (which had an interest rate of 7.6%) with her mortgage to reap a better rate.
“Technically, she’s taking out more debt, but because it’s a 15-year mortgage, and her rate is 3%, her total payment and interest paid are lower. When we walked through the numbers together, she realized that she now had an extra $1,200 a month to beef up her retirement savings. She’s feeling really excited about that.”
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