In 1788, the House of Bourbon, rulers of France over 200 years, discovered their decadent and wasteful ways had made them broke. No one would lend them any more money. For the first (and last time) in over 400 years, the French Monarchy decided to draw up a budget. It wasn’t pretty. France’s expenses were greater than its revenue by 20%! The leading cause of this mess? Nearly 50% of their revenue was used to pay interest on their debt incurred which tied up all financial flexibility. An attempt to tax men of property, the nobility, set off a chain of events which lead to the French revolution and the overthrow of the French Monarchy. In other words, debt can literally bring down kings.
Today, we live in an age of debt that would make King Louis XIV blush. Collectively, we have negative savings rate. MSN Money reported an average American carries of 7.8 credit cards. We don’t blink taking out 40 year mortgages. Is our level of debt management completely out of control? What is the norm anymore? How do you measure up to the debt-saddled Jones (not a contest you want to win!)?
The Ideal Debt Ratios- the rule of 29/41
The Federal Housing Administration (FHA) insures mortgages in the United States for qualifying financial institutions. In an ideal scenario, FHA recommends the rule of 29/41. The 29% is a reference to the Front End Ratio which is a ratio found by the taking the cost of carrying your home monthly (mortgage, taxes, insurance) and dividing it into your tax-home pay. For example, assume your tax-home was $4,000/month. According to FHA, you ideally should not be paying for more than $1,160 month to carry your home. In the good old days of 2006, many lenders were willing to push the front end ratios to 33%-35% on account of rising housing prices.
The 41% is a reference to the Back End Ratio which is a ratio found by taking the cost of all your recurring debt (the cost of carrying your home, car loan, student loans, interest on lines of credit etc). and dividing it into your tax-home pay. According to FHA, and using the same example, above, your back end ratio should not be more than $1,640/month. Most lenders would accept a borrower with a back end ratio pushing 45% (now you know why the Bourbons couldn’t get a loan).
If you exceed both the front end and back end ratio, it is not the end of the world but it compromises your ability to weather any stormy financial weather.
What is the Ideal Level of Debt as Dollar Figure?
It depends. For mortgage debt, the Millionaire Next Door found that anyone wanting to achieve financial independence had to purchase a home that requires a mortgage that is NO more than twice the household’s annual realized income (all sources of income).
