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IF WE HAD TO PAY cash for college costs and for the homes we purchase, many of us couldn’t afford either until our 40s and perhaps later. That’s where borrowing money comes in. It allows us to buy things we can’t currently afford—and, for worthy goals like purchasing a house and getting an education, it can be the prudent thing to do.
The key is to make sure we don’t borrow too much. How much is too much? We might take our cues from three benchmarks. For starters, there are the two debt ratios used by mortgage lenders.
Lenders will typically let borrowers take on monthly mortgage payments—including principal, interest, homeowner’s insurance premiums and property taxes—equal to 28% of their pretax monthly income. If your gross income is $5,000 a month, that would mean a maximum mortgage payment of $1,400. This is the so-called housing ratio.
But before lending that much, banks will also assess borrowers using another measure: the debt ratio. This looks not only at the proposed mortgage payment, but also at other debt payments, such as student loans, credit cards and car payments. As a rule, lenders don’t want to see all these various debt payments consuming more than 36% of a borrower’s pretax monthly income.
The difference between the 28% housing ratio and the 36% debt ratio is 8%. That, in effect, is the maximum percentage of pretax monthly income that lenders believe borrowers should be devoting to nonmortgage debt payments. You might keep that in mind when thinking about the size of the car loans and amount of student debt that you take on.
That brings us to the third ratio, which comes compliments of the federal government. If you’re repaying student loans, it’s possible to get your monthly loan payments capped if they’re more than 10% of your discretionary income, which is defined as income in excess of 150% of the federal poverty level for your family size and state of residence. That might be more or less than 8% of your gross pretax income—but, for successful college graduates, it’ll likely be close to that figure.
The upshot: Try to cap the monthly payments on your nonmortgage debt at 8% of your pretax income. Do you make $5,000 a month? The 8% limit would mean monthly nonmortgage debt payments of no more than $400.
Indeed, if you’re a parent advising your teenage children on college choices, you might keep that 8% figure in mind. Think about your children’s desired career and hence their likely income, and steer them away from colleges that’ll leave them with loan payments above that 8% level. To be sure, your children could always apply for one of the government’s student loan forgiveness programs. But that could still involve making loan payments for up to 25 years—not something most parents would want for their kids.
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