What is a reasonable amount of debt?

By Elvis Picardo, CFA AAA
A:

It really depends on numerous factors - what stage of life you are at, your spending and saving habits, the stability of your job and your career prospects, your financial obligations and so on. But to keep it simple, let's assume that you are employed in a stable occupation, have no extravagant habits and are considering the purchase of property.

A good rule-of-thumb to calculate a reasonable debt load is the 28/36 Rule. According to this rule, households should spend no more than 28% of their gross income on housing expenses (including mortgage payments, home insurance, property taxes, and condo fees), and a maximum of 36% on total debt service (i.e. housing expenses + other debt such as car loans and credit cards).

So if you earn $50,000 per year and follow the 28/36 Rule, your housing expenses should not exceed $14,000 annually or about $1,167 per month. Your other personal debt servicing payments should not exceed $4,000 annually or $333 per month.

Further assuming that you can get a 30-year fixed-rate mortgage at an interest rate of 4%, and that your monthly mortgage payments are a maximum of $900 (leaving $267, or $1,167 less $900 monthly towards insurance, property taxes and other housing expenses), the maximum mortgage debt you can take on is about $188,500.

If you are in the fortunate position of having zero credit card debt and no other liabilities, and are also thinking about buying a new car to get around town, you can take on a car loan of about $17,500 (assuming an interest rate of 5% on the car loan, repayable over five years).

To summarize, at an income level of $50,000 annually or $4,167 per month, a reasonable amount of debt would be anything below the maximum threshold of $188,500 in mortgage debt and an additional $17,500 in other personal debt (a car loan, in this instance).

Note that financial institutions use gross income to calculate debt ratios, because net income or take-home pay varies from one jurisdiction to the next, depending on the level of income tax and other deductions. Spending habits should be determined by take-home pay, however, since this is the amount that you actually receive after taxes and deductions.

So in the above example, assuming that income tax and other deductions reduce gross income by 25%, the net amount left to manage other household expenses (based on $3,125 of take-home pay - or 75% of $4,167 - and $1,500 in housing expenses and other debt servicing expenses) would be about $1,625.

Of course, the above debt loads are based on the present level of interest rates, which are currently near historic lows. Higher interest rates on mortgage debt and personal loans would reduce the amount of debt that can be serviced, since interest costs would eat up a larger chunk of the monthly loan repayment amounts.

While an individual's preferences ultimately dictate the amount of debt that he or she is comfortable with, the 28/36 Rule provides a useful starting point to calculate your reasonable debt load.

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