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What is Debt Load?
Debt load is a creditor term that is used to profile the total amount of debt that a consumer is carrying. This profile will determine if a consumer is carrying a safe or excessive amount of debt. Creditors and other lenders use various methods to calculate your debt load. The most common method is called the Debt-to-Income Ratio.
What is a Debt-to-Income Ratio?
A Debt-to-Income Ratio is the simplest method that a creditor or lender may use to compare the amount of your take-home income with the amount of your overall debt, excluding your mortgage or rent payment. This method will tell the creditor or lender what percentage of your take-home income is being used to pay for non-mortgage related debt.
How do I calculate my Debt-to-Income Ratio?
There are three parts to calculate your Debt-to-Income Ratio. Let's review below.
Part 1 - Take-home income:
This is the amount your paycheck reflects after all your deductions. Take-home income can come from your job wages, sales commissions, company bonuses, alimony, child support, tips, interest on money, company dividends, social security, pensions and other government assistance. Below are four methods that can help you to calculate your take-home income.
- If you are paid weekly then you must multiply your weekly take-home income by 52, then divide by 12, giving you your monthly take-home income.
- If you are paid every other week then you must multiply your take-home income by 26, then divide by 12, giving you your monthly take-home income.
- If you are consistently paid the same amount monthly then simply use, that amount.
- If you are paid a salary plus commissions that fluctuate up and down each month, the best way to calculate your monthly take-home income is to add up your take-home salary with commissions over the last 12 months (January 1st to December 31st), then divide by 12.
Part 2 - Monthly Debt Payments:
This is the amount you owe to your creditors each month, excluding mortgage, rent, utilities, and taxes. Monthly debt payments include:
- Credit card payments
- Student loan payments
- Auto or Other Vehicle loan payments
- Bank or Credit Union loan payments
- Medical or Dental Bills payments
- Computer or Electronic items loan payments
- Furniture or Appliance items loan payments
Part 3 - Debt-to-Income Ratio formula:
Take your calculated total "monthly debt payments" and divide it by your calculated total "take-home income" and this will give you your Debt-to-Income Ratio percentage.
Here's an example:
- Step 1 - Monthly take-home income is $2,000
- Step 2 - Monthly debt payments are $700 (auto loan, credit cards, etc.)
- Step 3 - Take $700 (debt payments) divide by $2,000 (take-home income) = 35%
- 35% is your Debt-to-Income Ratio percentage
Note: Refer to Debt-to-Income Ratio Worksheet, located in the "Worksheets" button above. You should print this worksheet and use it to see what your Debt-to-Income Ratio is and how it measures up with creditors.
How do creditors view my Debt-to-Income Ratio?
As a general rule of thumb, creditors and lenders may follow these Debt-to-Income Ratio percentages when granting credit approval.
- Level 1 - Debt-to-Income Ratio is less than 10%:This is the best range for obtaining credit. You are in great financial shape. You should continue applying your financial methods for staying out of debt.
- Level 2 - Debt-to-Income Ratio is greater than 10%, but less than 20%:You are still in a good range where a creditor will see you as a potential candidate for extending credit. With these ratios you could easily accelerate your debt payments, therefore decreasing your Debt-to-Income Ratio to level 1. Suggested Solution: You may want to develop a monthly spending plan to help pay off debt earlier and avoid taking on new debt payments.
- Level 3 - Debt-to-Income Ratio is greater than 20%, but less than 35%: Your range for obtaining credit will be questioned at this level. At these ratios, creditors will take a good look at your take-home income and monthly debt payments. Supporting documents may have to be supplied to the creditor or lender to verify take-home income. Suggested Solution: At this level, you should take a serious look at your spending habits and either increase your take-home pay or decrease your debt payments. If not, you may not be able to pay bills, which could cause serious financial problems in your family life. A credit counseling agency may be the best solution to help you regain control of your financial life.
- Level 4 - Debt-to-Income Ratio is greater than 35%:You are considered a high credit risk. Your chances of obtaining credit will be slim to none. At this ratio or higher, creditors will consider that your take-home income is not enough to support your current debt payments and monthly bills. Suggested Solution: At this level, you need the help of a qualified professional (such as a counselor with a reputable credit counseling agency or a bankruptcy attorney) to help you get out of debt.
What is my Debt-to-Income Ratio goal? Ideally, the lower you can get your Debt-to-Income Ratio percentage the better your chances are for obtaining credit. Your goal is to obtain and maintain a Debt-to-Income Ratio between 10% to 19%. Anything above 20% could be questionable for credit.
How can I change my Debt-to-Income Ratio?
It is possible to change your Debt-to-Income ratio for the better. Changing your Debt-to-Income Ratio can be accomplished by:
- Increasing your monthly take-home pay
- Decreasing your monthly debt payments
Here are some scenarios to review:
| Scenario 1 |
| Take-home Income: |
Monthly Debt Payments: |
Debt-to-Income Ratio: |
| $2,000 |
Auto loan $375 |
$700 divided by $2,000 |
| |
Credit cards $150 |
35% is your ratio |
| |
Student Loan $50 |
|
| |
Personal Loan $125 |
|
| |
Total Payments $700 |
|
| Scenario 2 |
| Take-home Income: |
Monthly Debt Payments: |
Debt-to-Income Ratio: |
| $2,000 |
Auto loan $275 |
$375 divided by $2,000 |
| |
Credit cards $50 |
19% is your ratio |
| |
Student Loan $50 |
|
| |
Personal Loan $0 |
|
| |
Total Payments $375 |
|
Note: With the same take-home income of $2,000, by paying off some credit cards and personal loan you could reduce your ratio score for the better from 35% down to 19%.
| Summary of Debt-to-Income Ratio scenarios: |
| Scenario |
Monthly Debt Payments: |
Debt-to-Income Ratio: |
| 1 |
$700 |
35% (high credit risk) |
| 2 |
$375 |
19% (good credit risk) |
Note: As you can see by lowering your monthly debt payments you can improve your Debt-to-Income Ratio, therefore improving your chances of obtaining credit. The key is to keep your monthly take-home income steady or increase it while reducing monthly debt payments.
Why should I monitor my Debt-to-Income Ratio?
As you can see from the different scenarios outlined above, keeping track of your monthly debt payments is very important to your Debt-to-Income Ratio and creditworthiness. By creating a livable spending plan you will be able to allocate the necessary monthly payments to all debts, therefore giving you a clear picture of your available spendable income. Knowing your spendable income will help you:
- Make good financial decisions when applying for a new loan, credit card or purchasing a more expensive automobile.
- Keep your Debt-to-Income Ratio in line (below 20%).
- Keep you and your family from having financial problems that could lead to collections, wage garnishments, lawsuits and eventually, bankruptcy.
What is the 20/10 Rule?
The 20/10 Rule is another method that lenders often use to grant consumer credit. The 20/10 Rule has two parts with the "20" dealing more specifically with total debt as opposed to the monthly payments associated with such debt, while the "10" deals with the payments.
The 20 Refers to: - Your total annual household debt (excluding your mortgage) should not exceed 20% of your net annual take-home income. Net take-home income is what you actually take-home after taxes and deductions.
Here's an example:
- Your total net take-home income is $48,000 a year
- The formula: Take $48,000 (times) 20% = $9,600
- Your total consumer debt under the "20" Rule shouldn't exceed $9,600
The 10 Refers to: - Your total monthly debt payments (excluding your mortgage payments) should not exceed 10% of your net monthly take-home income.
Here's an example:
- Your total net take-home income is $48,000 a year
- The first formula: Take $48,000 (divide by) 12 = $4,000
- The second formula: Take $4,000 (times) 10% = $400
- Your total monthly payment under the "10" Rule shouldn't exceed $400 per month
What is the 28/36 Rule?
The 28/36 Rule is another method that mortgage lenders may use to grant credit. The 28/36 Rule has two parts and works like this:
The 28 Refers to: - Your total mortgage payment (principle & interest), including taxes, insurance, mortgage insurance and homeowner's dues should not exceed 28% of your gross monthly income. Gross monthly income is what you actually make before taxes and deductions are taken out.
Here's an example:
- Your total gross income is $72,000 a year
- The first formula: Take $72,000 (divide by) 12 = $6,000
- The second formula: Take $6,000 (times) 28% = $1,680
- Your total monthly payments under the "28" Rule shouldn't exceed $1,680 of your $6,000 gross monthly income.
The 36 Refers to: - Your total mortgage payment (principle & interest), including taxes, insurance, mortgage insurance, homeowner's dues plus other debts (e.g., auto loans, student loans, credit cards, etc) should not exceed 36% of your gross monthly income.
Here's an example:
- Your total gross income is $72,000 a year
- The first formula: Take $72,000 (divide by) 12 = $6,000
- The second formula: Take $6,000 (times) 36% = $2,160
- Your total monthly payments under the "36" Rule shouldn't exceed $2,160 of your $6,000 gross monthly income
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