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What percentage of my income should I have as debt?

For many people, debt is essential. If you want to buy a car or own your own home you will probably have to take out some debt to enable you to do this. Indeed, the average household debt in the UK (including mortgages) was £55,514 in May 2012.

If you have debt, you may be concerned that you have too much debt based on your household income. But, how do you work this out? And what percentage of your income should you have as debt? We answer these questions.

What is your ‘debt to income’ ratio?

To work out whether you have too much debt, you should calculate your ‘debt to income ratio’. This is a crucial personal financial health indicator and it shows you how much debt you have in relation to your household income. Working out this ratio can help you work out whether you need to take steps to reduce your debt.

There are several ways to calculate your ‘debt to income’ ratio, and the most common method is below.

Working out your debt to income ratio

To work out your debt to income ratio you will need to know what your household income is every month. Work out your monthly gross income (before any deductions or taxes are taken out) and don’t forget to include all income including overtime, bonuses and benefits.

Once you have worked out your monthly household income you should work out what you pay to your debts every month. Work out your average credit card payment every month and include other debts such as your mortgage payment, car payment, and other loan payments, such as home equity loans and personal loans.

Now that you have the information you need, you should divide your monthly debt payments by your monthly income.

For example, if you earn £1,500 a month on average and you have debt payments of £600, your ‘debt to income’ ratio would be:

£600/£1,500 = 0.4 (or 40 per cent)

What percentage of income should you have as debt?

Most banks and financial professionals agree that you should keep your debt-to-income ratio at less than around 36 per cent of your gross income.

For example, in the USA, mortgage lenders will agree a loan if your ‘debt to income’ ratio is under 36 per cent. US News indicates ratios of 37 to 42 per cent are not bad, 43 to 49 per cent require some proactive work, and 50 per cent or above likely require some formal professional debt repair help.

What to do if your debt is too high for your income

If your debt to income ratio is over 45 per cent, you may have to take some proactive steps to bring this down. To improve your debt to income ratio, you have two options:

  • Increase your income
  • Lower your expenses

Increasing your income might involve you working overtime or taking on a second job. You could review your investments to increase your returns and make sure you are claiming all the benefits to which you are entitled.

Lowering your expenses can involve cost saving measures such as switching your phone or utility providers, cancelling non-essential direct debits, eating out less and not taking holidays. Debt consolidation can also help you to reduce your monthly debt payments.

Working out a monthly budget in order to reduce your expenditure is a good first step to bringing your debt to income ratio to a more manageable level.

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