Last Updated Oct 7, 2011 11:19 AM EDT
QUESTION: Is there a rule when it comes to financing a car or a house? What percentage of monthly disposable income is safe to use as a car or mortgage payment?
Michael L, AGE: 27
RAYS ANSWER: I really like this question, especially since it comes from a young adult who is seeking to be responsible with respect to his debt payments and cash flow.
First a little financial education is in order here. What you are asking about is called the debt-to-income ratio. The standard debt-to-income ratios are the housing expense, or front-end, ratio and the total debt-to-income, or back-end, ratio. This is the percentage of the debt payment that is in relation to your income. Here's how it works.
- Front-end ratio: The housing expense, or front-end, ratio shows how much of your pre-tax gross monthly income would go toward the HOUSING payment. As a general guideline, your monthly mortgage payment, including principal, interest, real estate taxes and homeowners insurance, should not exceed 28 percent of your gross monthly income. To calculate the amount you could pay for a total housing payment, multiply your annual salary by 0.28, then divide by 12 (months). The answer is your maximum housing expense ratio.
- Back-end ratio: 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, condominium fees, etc. In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your total 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.