What Ratio Should I Have of Good/Bad Debt?

Not all debt is created equal. Certain debts are much more deleterious to your finances than others. Credit card debt and auto loans are both examples of bad debt. On the other hand, mortgage loans and student loans are examples of good debt. In the long run, good debts work to the advantage of your finances. Understanding the difference between good and bad debt is critical in determining whether you have too much debt. The debt-to-income ratio is the most reliable way to find out if you are carrying too much debt. Some financial experts recommend including both good and bad debt in this calculation, while others advocate including only bad debt since it is the most damaging. In this post, we’ll explain more about the good/bad debt ratio and reveal the ratios most lenders recommend.

Debt-to-Income Ratio

A debt-to-income ratio reflects the amount of debt you carry relative to your income. The traditional debt-to-income ratio includes both good and bad debt. If your goal is to determine your debt overload, you should leave good debt out of the calculation. However, if you want an overview of your total debt situation, you should include both types of debt. If your debt-to-income ratio is less than 30%, your debt situation is excellent. A ratio of 30%-36% is good, while a ratio of 36%-40% is borderline. If your ratio is 40% or higher, you may be overextended. To figure out your debt-to-income ratio, add up all of the following expenses and divide them by your monthly net income (take-home pay):

• Monthly mortgage payment
• Monthly car payment
• Monthly student loan payment
• Monthly minimum credit card payment times two
• Monthly child support or alimony payments
• Other monthly loan payments

Bad Debt Only Ratio

To determine your debt overload, you would include only bad debts in your debt-to-income calculations. Bad debts are all debts except mortgage payments and student loan payments. Figuring out your bad debt ratio is simple: add up the amount you spend monthly on bad debt and divide it by your monthly income. Multiply the number by 100 to get a percentage. The recommended bad debt ratio is 10% or lower. A higher ratio is indicative of debt overload.

For instance, let’s say you make $3,000 per month. We’ll assume you devote $300 per month to credit card payments and $450 per month to your car payment. Your bad debt ratio would be $750/$3,000 for a ratio of 0.25, or 25%. In other words, you are spending 25% of your income every month on bad debt, which is a very high percentage.

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