THIS ARTICLE DISCUSSES the scenario for consideration in this series of presentations on using debt wisely: Is the statement, “You should be able to service a mortgage comfortably that requires a monthly payment of about 25 per cent of your gross monthly household pre-tax income,” true or false?
This statement is generally true for the average person in their 20s or 30s. In personal financial planning terms, there is the 28/36 rule which serves as a guide in gauging the amount of debt that is a reasonable amount to hold. This rule weighs your mortgage debt and your total debt as a percentage of your total gross monthly income – mortgage debt that is about 28 per cent of your total gross income or less is considered a reasonable amount of mortgage debt. Similarly, the total of all debt – mortgage debt plus all other debts – would be in a reasonable range if that total debt is about 36 per cent of your monthly gross income or less.
Obviously, the amount of debt held will vary from person to person according to their stage in life; how they see their future job prospects and even how they feel about holding debt. For example, retirees typically strive to be free of mortgage debt during the retirement stage. In fact, for retirees generally, any debt is too much.
Mortgage debt generally needs to be serviced on a monthly basis, so you will also be guided by the confidence you have in being able to hold a steady job as well as earning cost of living increases or promotion over the period of the mortgage loan. Also, if there are a number of children in your family who are dependent on your financial support, you will likely be more cautious in taking on significant debt.
Your entire attitude to risks also guides the amount of debt that you may hold. For example, an entrepreneur who seeks the once-in-a-lifetime opportunity to test their business plan may push the debt level well over these guidelines. Yet, that is a specific choice guided by the willingness to undertake commercial risks. Colonel Saunders would have use significant credit in launching his Kentucky Fried Chicken product . . . and that was in the latter days of his life. Fortunately, he undertook mammoth risks and earned commensurate returns.
The 28/36 rule is a ready test of the reasonableness of the amount of debt you hold. If you are slightly over, regular checks, say annually, will serve to monitor that your debt burden is not growing out of control. A total debt ratio of 50 per cent or over indicates financial problems present or looming. It may be time to seek professional debt management advice in order to get your debt burden under control.
Whether you assess your debt burden or not, be aware that whenever you approach a financial institution or other creditor for a loan or advance, they have similar techniques of assessing the reasonableness of your debt burden.
Let us consider an example of gross household income totalling $60 000 per year. Let us assume an effective income tax rate of 15 per cent, or a tax payment of $9 000 per year. The mortgage payment including the insurance and property taxes should not exceed $16 800 per year or $1 400 per month. All other debt (car loan, hire purchase, store credit, credit card and so on) should not exceed $4 800 per year or $400 per month. That leaves a balance of $2 300 for living expenses, and savings.
Today’s scenario explores the reasonable range of debt as your guide for monitoring the amount of debt you hold. Even when using debt wisely, you need to keep track that that debt does not grow out of control and become an undesirable stressor.
• Louise Fairsave is a personal financial management advisor, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. She can be contacted at louisefairsave@nationnews.com.
This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.