Most people have some debt. It can be a mortgage, a car loan, a student loan, a credit card balance, or even some debts with commercial and micro-finance houses.
Having debt is not a bad thing, as long as you are taking the necessary steps and actions each month to pay it off. Having too much can make you financially—and generally—unhealthy in life. If you think you might be in this situation of having too much debt, take some time to add up what you owe and decide what that number means to you.
Do you have too much debt?
One of the easiest ways to figure out how much debt you have is determining your debt-to-income ratio.
This figure compares your monthly payments toward the debt to your monthly income. There are two ways to do this: You can calculate your debt-to-income ratio, including both good and bad debt, or you can leave out good debt (student loans, mortgage payments) and only take into account bad debt.
If you want to measure your debt overload, it’s usually best to calculate the ratio by considering only lousy debt. On the other hand, if you want a total picture of your debt, include both good and bad debt.
How to calculate it
For example, let’s say you want to measure your debt overload (bad debt only). Add up the amount you spend each month on bad debt, for example, credit cards, personal loans, extra-financing, business houses, and lenders, and divide that amount by your total monthly income. Then multiply that number by 100 to arrive at a percentage. The result is your debt-to-income ratio.
For example, suppose you earn $1,000.00 a month and spend $200.00 on credit card payments, $150.00 on extra-financing, and $50.00 on a business. Your ratio calculation would be $400.00 / $1,000 = 0.40.
Multiply that by 100 for a debt-to-income ratio of 40%. In this example, you spend 40 percent of your income on lousy debt—too high a number.
When it comes to debt, whether it’s good or bad, the lower your debt, the better. A debt ratio beyond 15% is too high and is often a sign that you are over-indebted. In this scenario, you would have too much bad debt because, by the time you want to invest in a business or a home, the amount of credit you would have left would be too low.
Understanding your total debt
Now, if what you want -and it is something we all need to do month by month- is to evaluate your total debt picture, including good debt and bad debt, the calculation is the same as in the previous example with the only difference that you include all of your debt instead of just what is considered harmful or consumer credit.
To calculate your total debt to income ratio, add your monthly debt payments. This includes payments on credit cards, student loans, mortgages, auto loans, and other loans or credit cards.
Next, add up your total monthly income, including wages, gifts, business, alimony or child support, bonuses or dividends, etc.
Divide your total debt payments by your total income, multiply by 100, and have the percentage of your income toward paying your entire debts.
Considering both good and bad debt, your total debt-to-income ratio should be 36% or less. A ratio of less than 30% is excellent, while a ratio of more than 40% is a red flag for possible financial disaster.
If you determine that you have too much debt, you can put together a plan to reduce your debt. It will make your finances easier to manage, but it will also improve your credit record, so you have more opportunities for timely credit when you need it.
Do not forget that the secret of a healthy level of debt and, in general, of a healthy financial life is control: of expenses, of emotions, of purchases, savings and debts. If you want to have a healthy debt limit, do not forget to make a month-to-month budget, keep track of your daily expenses, and only apply for credits that you know you will be able to pay promptly and bring benefits to your life beyond the short-term consumption.