How much debt is too much? Depends!

To be fair, looking for bad advice in US News & World Report is a lot like trying to find something beautiful in the Louvre.

It's just too easy. Last week, I took US News to task for advising parents on taking out student loans when they can't afford their own mortgage payments.

This week, Rick Newman, the magazine's chief business correspondent, offers this horrible, horrible, horrible piece of advice: "The average debt-to-income ratio, or DTI, is 125% today. Economists roughly consider a 100% DTI ratio to be "normal" or healthy. So if you owed a combined $125,000 on your mortgage, car loans and other obligations and earned $100,000 in take-home pay, you'd want to pay down your debt by $25,000, or 20%, to be in the safe zone."

Here's the problem: in 2007, the median household income in the United States was $50,233.

Using the 1:1 guideline, that would mean that the median family couldn't have a mortgage of more than $50,233 -- which would require a down payment of more than $50,000 to buy a starter condo in most areas.

But if a starter home has the same monthly cost as an apartment rental, is a family with no debt and no equity really doing better than a family with a mortgage and a chance at building wealth through homeownership (to say nothing of the tax breaks)?

Therein lies the second problem with this metric: not all debt is created equal. Consider these two scenarios:
  • Family A earns $50,000 per year and has $50,000 in credit card debt from exotic vacations, luxury handbags, and online pornography subscriptions. The debt is accumulating interest at a rate of 24% because it is in default.
  • Family B earns $50,000 per year and has 30-year fixed rate mortgage of $100,000 at 5% on a home that is now worth $130,000. They have no other debt.

Based on debt-to-income ratios, Family A is doing fine and Family B needs to pay off $50,000 in debt to be "in the safe zone." Obviously, that's crazy. It is impossible to make blanket statements about healthy debt to income ratios for three reasons:

  • It depends on the interest rate. Variable rate debt at 25% interest is different from fixed-rate debt at 5%.
  • It depends on what you're financing: debt backed by appreciating assets can be healthy. Debt backed by depreciating assets almost never is.
  • It depends on your age: As people get closer to retirement, mortgages (ideally) are closer to being fully paid off. For young people, a significant debt load may be necessary to make home ownership possible.
A better metric to look at -- one that lenders often look at -- is how much of your monthly income is consumed by debt obligations, and then subtracting the amount that would be consumed by other expenses if you didn't have that debt. For instance, if your mortgage plus taxes and insurance is $1,000 a month but a rental would also cost $1,000 a month, your mortgage isn't really costing you any extra money: you have to live somewhere, and you might as well build equity for yourself instead of for a landlord.
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