Credit & Debt
Sketched: What’s the Right Amount of Debt
It's a tricky question... and one that may not have an exact right answer.
Economists at The Federal Reserve Bank of St. Louis have written extensively on shifting consumer spending patterns and also have created online courses meant to equip consumers with economic education to better manage their personal finances in the future.
They argue the single most important measure is the Debt-to-Income Ratio (DTI), which equals total monthly debt divided by gross monthly income. This ratio has two components, a so-calledfront end that reflects housing expenses (rent, or mortgage plus insurance, insurance, taxes, association fees and/or maintenance) and a back end that includes all additional recurring debt payments (auto financing, minimum credit card payments, student loans, child support, alimony and any legal judgments).
Some lending institutions sometimes ascribe to a “28/36" guideline in assessing appropriate debt loads for individuals, meaning housing costs should not exceed 28 percent of gross monthly income, and back end costs should be limited to an additional 8 points for a total of 36 percent.
So, using this model, if your pre-tax monthly income is $10,000, you would spend no more on housing each month than $2,800, and additional debt obligations should add only another $800. Do you meet the 28/36 criteria?
In helping consumers to better manage monthly cash flow, some experts cite two additional metrics: Liquidity Ratio and Savings Ratio. The Liquidity Ratio measures how much cash you have on hand to cover all monthly expenses from debt to food, in the event you lose your income due to unforeseen circumstances. As a general rule, holding 3-6 months worth of cash and cash equivalents (checking and savings balances and investments that can easily be cashed in) can provide a safe cushion for emergencies. Divide cash plus equivalents by total monthly expenses, which include everything from debt to food and transportation.
Your Savings Ratio is simply the percentage of income saved each month. Always save. If you set aside $100 per month in a pretax account like a 401(k) for 25 years earning just 5%, you would end up with $57,276. Imagine if you saved 10 percent of your income annually.
To learn more, visit http://www.investor.gov/tools/calculators/compound-interest-calculator
Bottom line, try to remember these three principles:
Live within your means.
Keep enough cash to cover 3-6 months of expenses.
Save something every month.
Adam Johnson advises senior executives on communicating to financial markets. He is a former business anchor at Bloomberg Television and worked as an investment professional for two decades.