I’ve been in finance for a long time and I do not believe debt is a bad thing. Debt is a powerful tool if used correctly and in moderation.  If someone hands you a chainsaw, you’re going to want to learn how to use it first before turning it on because someone can get hurt. Debt is the same.

The average American household has $15,800 (Federal Reserve, Joint Economic Committee, Sallie Mae, TransUnion, 2012) of credit card debt.  In the worst credit card debt cities in America, the average household owes 13-15% of its pre-tax income to credit card companies (Forbes), which means if you make pre-tax $100,000/year, you have total credit card debt of about $14,000.

Now, let’s get on with the math. We’re going to calculate a “debt-to-income” ratio (DTI).  You can do a DTI ratio on all debt (we’ll do that first) and then a DTI on “bad” debt, which I define as debt that has an interest rate above 7% (I’m being really conservative here, some people say 10%).

DTI Good and Bad Debt (Monthly numbers)

Mortgage payment (w/o insurance & tax. If you pay rent, put your rent payment in)      $2000
Car loan                                                                         $0
Student loans                                                                              $500
Credit card minimum payments (if you don’t know this, take 2% of total balance)   $400
Appliance, specialty, family or other debt (includes child support or alimony)             $0
Total                                                                                      $2900
Monthly Pre-tax income (all income including rents, bonuses, salaries)                     $9000

DTI = $2900/$9000 = .32 * 100 = 32%
0 -36% = Healthy DTI
37-42% = Not bad, but you should be trying to cut your debt
42 – 49% = You could be in trouble financially and soon! Start cutting now!

DTI Bad debt only – this can help you figure out if your credit card debt alone is high, include all debt with an interest rate above 7% (include credit cards that change to a higher rate after a few months)

Bad Debt DTI (Monthly numbers)
Car loan (if above 7%)                                                                                              $0
Credit card minimum payments (if you don’t know this, take 2% of the total balance)         $400
Appliance, specialty, family or other debt (not child support or alimony)                       $0
Total                                                                                                                      $400
Monthly Pre-tax income (all income including rents, bonuses, salaries)                       $9000

DTI = $400/$9000 = .04 * 100 = 4%
0 -10% = Healthy DTI
10-15% = Not bad, but you should be trying to cut your debt
+ 15% = You could be in trouble financially and soon! Start cutting now!

Here are some tips and tricks on how to manage your bad debt payments so you can pay them off sooner!