Our nation's debt to income ratio

Featured Article by Jordan Graham

What ever happened to the stigma associated with paying interest?

There are still some people -- usually older than 50 -- who recoil at the thought of paying interest for something like a couch or a car. By contrast, Americans today are so culturally addicted to overspending that we think nothing of buying things for which we cannot afford to pay cash. And the more we borrow, the more expensive it becomes to borrow.

One of the key benchmarks that lenders use to evaluate a new mortgage application is the Debt to Income Ratio ("DTI".) It's calculated by adding up the monthly minimum payments required to sustain a borrower's current credit accounts plus the new loan in question and dividing by the borrower's gross monthly income. Here's an example for a hypothetical (but typical) American borrower who is seeking to take some equity out of his home with a Home Equity Line of Credit ("HELOC"):

• First Mortgage: $1,780
• Car payment: $ 425
• VISA cards: $ 300
• Student loans: $ 325
• Furniture payments: $ 185
• subtotal: $3,015
• New HELOC: $ 395
• Total: $3,410

Monthly Income: $7,000 (gross; that's $84,000 a year)

DTI: (3,410 / 7,000) = 48.71%

This borrower would probably be approved for the new HELOC; many lenders will let you commit to a DTI of up to 50%. Bear in mind that after taxes, his monthly take-home income is $5,040 -- so after making the minimum payments on his debt obligations, he has $1,630 left.

Sounds like a lot of money, right?

But remember -- he's only making minimum payments, which means he's effectively getting nowhere on paying down his debts. Quite likely, he has an adjustable mortgage ("ARM") -- his new HELOC is certainly adjustable -- which means that his interest payments can increase over time, further chipping away at his $1,630 per month.

Never mind saving for retirement, or college fund planning.

Sound familiar? Far too many Americans push their fears about their own debt load to the backs of their minds every night so they can get to sleep.

Let's look at another borrower whose finances are structured a little differently, split between "Mandatory Spending" (think of that as being installment loans, like car loans or financed furniture) and "Interest." How easily would sleep come to you in this scenario?

	Mandatory spending	Interest	Total (% of income)
2005	63%	10%	73%
2010	67%	11%	78%
2015	73%	13%	86%
2020	81%	19%	100%
2025	94%	24%	118%

I'll identify the borrower in this case -- it's the US Federal Government (data from the Congressional Budget Office, December 2005, "The Long Term Budget Outlook, Scenario One".) I'll start by saying that under no circumstances would a lender lend anything to a person with this kind of cockamamie financial plan.

It's not sustainable. The tough part is that "Mandatory Spending" includes Social Security and Medicare, which sooner or later will have to be cut -- we simply cannot spend more money than we take in. Borrowing to pay our Mandatory Spending bills gets more and more expensive, too, so that's not a viable option.

I read an article in this morning's New York Times about Chile, which “spends practically nothing on interest payments, because we have been able to reduce public debt” and instead use the savings for social programs, according to Chile's Finance Minister, Andres Velasco.

I know that there is a vast difference between the global priorities of the US and Chile, but I long for a culture of sustainability -- in which we act today in such a manner that we will be able to afford sustaining our lifestyles in the years to come.

By Jordan Graham

Permission to republished by Jordon Graham Copyright 2007