Debt—the word often has a negative connotation as there are many stories of how individuals and companies with too much debt have headed down a road to financial ruin. However, debt can often be a good thing, if managed properly.
Debt can help companies grow and help people purchase valuable assets that are otherwise too costly, such as a house, which in the long term would improve their financial condition. The amount of debt also depends on the interest rate that you're paying on your debt. An acceptable, low-interest rate, such as those found on mortgages, makes debt manageable. On the other hand, high-interest rates, such as those found on credit cards, can often lead to debt levels spiraling out of control.
This is not to say that an individual should constantly be taking on debt. Like most things, a moderate amount that is carefully monitored and within one's financial means is the right level of debt. Generally, what is considered a reasonable amount of debt depends on numerous factors, such as what stage of life you are at, your spending and saving habits, the stability of your job, your career prospects, your financial obligations, and so on. But to keep it simple, let's assume that you have stable employment, have no extravagant habits, and are considering the purchase of a property.
- In order to keep your debt load under control, a household may look to the so-called 28/36 rule.
- The 28/36 rule states that no more than 28% of a household's gross income be spent on housing and no more than 36% on debt service.
- This heuristic looks at pre-tax income, so a more conservative measure would be to apply the rule to after-tax take-home pay.
The 28/36 Rule
This includes mortgage payments, homeowners insurance, property taxes, and condo/POA fees. And households should spend no more than a maximum of 36% on total debt service, i.e. housing expenses plus 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).
Gross Income vs. Net Income
Note that financial institutions use the 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 paycheck 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%, you're left with $37,500 or $3,125 monthly. This means that you can allocate $10,500 or $875 monthly to household-related debt and $250 to other debt, for a total debt amount of $1,125 per month or $13,500 annually.
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.
The Bottom Line
Debt can be a financial benefit when managed properly. While an individual's preferences ultimately dictate the amount of debt that they are comfortable with, the 28/36 rule provides a useful starting point to calculate a reasonable debt load.