Funny about Money

The only thing necessary for the triumph of evil is for good men to do nothing. ―Edmund Burke

Debt-to-Income Ratio: Frugalist begs to differ

So the Financial Wizard par Excellence is arguing that M’hijito, who earns a salary that is exactly at the median income for bankruptcy purposes, should be able to shoulder a great deal more of the Investment House mortgage than he agreed to. Our agreement was that he would cover one-third of it (having contributed a third of the down payment) and I would carry the other two-thirds. When we sell the chateau sometime in the future at an outrageous profit, we’re to divide our incalculable riches accordingly.

Fact is, he’s carrying more like 40 percent of it.

FW trots out the debt-to-income ratio to support his position:

The total debt-to-income, or back-end ratio, shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees. In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your debt-to-income ratio, multiply your annual salary by 0.36, then divide by 12 (months). The answer is your maximum allowable debt-to-income ratio.

Hm. Let’s think about that.

My gross income is $62,500. In theory, then, I should be able to tolerate a debt load of $1,875. A person with the state’s median gross income should be able to afford a total debt of $1,301.91.

And…uhm…what does such a debtor eat? Guess he doesn’t have to worry about dieting, eh?

My net monthly income is $3,000—actually, it’s more like $2,864 with the twice-a-month furloughs. The cost of operating my house and paying regularly recurring bills such as long-term care insurance and utilities comes to about $840 a month. In the winter it’s a little less, but one ignores the high summer bills at one’s peril. My house is paid off, so I have to self-escrow the costs of homeowner’s insurance and property tax, which when combined with the car insurance bill average out to around $350 a month. The combined cost of all other expenses—food, household goods, gasoline, car repairs, home repairs, pool chemicals, yard items, veterinary bills, medical and dental copays, and on and on and on—comes to about $1,200. I do charge these things on AMEX by way of collecting a couple hundred dollars in kickbacks once a year, but I pay the charge card bill in full every month.

I live pretty frugally: don’t travel, don’t subscribe to cable or cell services, rarely eat out, don’t buy many clothes (and none that have to be dry-cleaned), wash my own car, clean my own house, grow some of my own food, abstain from expensive hobbies, don’t even go to movies.The only debt I have is the $170 bill for the Renovation Loan (soon to be paid off) and my $800/month share of the house mortgage, for a total of $970. I presently put $400 a month in savings toward survival after the coming layoff. So…

  $840 monthly set expenses
all other living & unexpected expenses
Reno Loan (second mortgage)
Investment House mortgage
     350 tax & insuranceself-escrow
emergency savings

Tha’s funneh. Seems to come to more than I’m bringing home! Cut emergency savings to a more ordinary $200 a month, and we still exceed my net income by $696 a month.

Okay, I admit it: the $800/month is a drawdown from savings. So $3,760 – 200 – 800 = $2,760.

That’s right: a debt of a grandiose $170 a month brings my outgo to within $104 of my income…and that’s without any major bills: no pipes explode, no veterinarian proposes surgery, no dentist cries out for some expensive procedure, and the car’s transmission continues to run flawlessly.

If $1,875 of my income were committed to debt service, I would have a munificent $1,125 left to live on. But it costs $2,760 for me to live rather modestly (some would say “ascetically”) in a small middle-class urban tract house.

Is there any question why most people are up to their schnozzes in revolving debt? If my debt-to-income ratio were maxed, the only way I could possibly get by would be to live on the cuff!

Allow me to propose a different debt-to-income ratio, one that is based on net income, not gross.

Obviously, the amount of debt a person or family can afford is a function of the amount of money the household brings home, not a never-never-figure whose total is effectively meaningless. What matters, when calculating what you can afford, is how much you have in your pocket, not how much you putatively “earn.”

If you hope to live within your means and your net is, say, $3,000 a month, you need to subtract your known living expenses plus a little for emergency savings from your take-home pay. What remains is the amount you can pay toward debt. Let’s say I were not facing unemployment in a few months, so I put aside a more normal $200/month toward the emergency fund: my regular needs would come to $2,410 less the second mortgage payment: $2,240 (i.e., $2,410 -$170). This would leave $590 a month ($3,000-$2,410) available to pay toward debt. That is 19 percent of my net income.

On a “good” salary in my region, I can afford to commit about 20 percent of net to debt payment. Spend much more than that, and presto-changeo! My lenders get rich on the interest I owe now and forever, world without end, amen.

Take-home pay is typically about 60 percent of gross pay. So a person with Arizona’s $43,400 median income brings home about $26,040, or $2,170 a month.

That would make a reasonable debt load right around $435 a month (20% of $2,170). Yes. For your mortgage or rent, your student debt, your revolving credit-card debt, whatever you owe Mom or Uncle Ernie…

By this guideline, M’hijito, who has no other debt, is already contributing $165 a month more than he can afford to our combined real estate venture.

Figured traditionally, the debt-to-income ratio suggests he should be able to afford $1,301 a month, leaving him with a miserly $869 a month to live on!

Here’s what I think: the standard debt-to-income ratio calculation is utterly unrealistic and unfair to consumers. First, a number like 36 percent way too large. Second, figuring the amount of debt a person can carry according to his or her gross income works a complete disconnect from reality! No one lives on gross income. We live on our net income! Because net, not gross, is what we have available to spend, net income is the figure that should be used to calculate a tolerable debt load.

The take-home message: Figure the amount you can pay toward loans of any and all kinds according to your net income, not according to your gross. Obviously, if you want to spend no more than you earn, you need to keep the debt load low enough that it plus your total other spending and saving needs come to no more than your take-home pay.

debt-to-income ratio = (net pay – spending needs – saving needs) ÷ net pay

The decimal fraction you get from this formula is the fraction of your net pay you can afford to spend on debt.

How hard is this?

Well, of course, real hard: who do you know who’s paying $435 a month to keep a roof over his head? And how many own their cars free and clear? Not many, I’ll bet, who don’t have a roommate, a spouse, or a life partner.

Few exercises demonstrate more clearly that good financial health (at least on the household level) entails getting out of debt and staying out of debt. It means pinching pennies as tight as you can, creating more than one income stream to maximize net pay, and doggedly snowflaking down revolving debt first and then finally mortgage debt. Quite a challenge, this “getting real” business.

Author: funny

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  1. You know, I have never understood the point of calculating anything-to-income ratios using gross income. Did that ever make sense? Seemed like you were always going to start off disadvantaged by at least 20% that way.

  2. As far as I can tell, it’s a scam used by lenders to persuade people that they can go into debt up to their eyeballs. Don’t worry. Be happy! You can afford it!

  3. I have heard so many people (esp students with major loans) say “I thought it was ok to borrow this much because the bank said I could.” Why do we let the people who benefit financially from our indebtedness get to be “experts” on how much is ok to borrow?

    When I was thinking about re-doing my decrepit kitchen, people said “It is a ‘rule of thumb’ to have kitchen renovations of up to 10% (or was it 20%?) of a home’s [inflated] value.”

    There was a scandal last year concerning college loan officers who had been getting consultant fees and vacations from private lenders. These were the ‘experts’ working for the colleges who advised students and families.

    All these things seem related to me.
    Thanks for the post.


    A nice little blog piece on this for future reference. At its peak LA averaged 102% 😀