Question

Melinda Dennis from Sewell, New Jersey, just graduated from college and is concerned about her student loan debts. While at her graduation party she got to talking with three of her cousins, Kyle, Mariah, and Hadrian, who have been out of school for several years and found they each have had somewhat different pattern with using credit and carrying debt. Kyle, who had taken a personal finance class, said he felt good about his credit management and mentioned he has a debt payments-to-disposable income ratio of 7 percent. None of the other three cousins even knew what such ratio was. Kyle offered to do the calculations for the other three cousins. After doing so, he found ratios of 20 percent for Melinda due to her student loan debt, 12 percent for Mariah due primarily to a car loan, and 16 percent for Hadrian due to both a car loan and credit card debt. The cousins are planning to get together next week and discuss what Kyle has found. What assessment and advice should Kyle give to his cousins?

Answer 1

Debt payments-to-disposable income ratio is a measure of the total amount of debt held by a person to the disposable income (after-tax income that is available for spending or savings) of the person. So if Kyle has a disposable income of $5000 per month, 7% of this ratio means that his monthly debt obligations are = 5000 * 0.07 = $350

Generally, lenders check this ratio based on the data of applicants who want to borrow money. Lenders prefer this ratio to be around 35% at most. The reason for this is that a higher value of this ratio can lead to a higher probability of default on debt repayments by the borrowers.

Other than the probability of default, a high value of this ratio can become a cause of financial stress for an individual as well. If someone has an income source that is not fixed, any big fluctuations can put them in a tight spot as they may find it hard to meet basic needs while simultaneously shelling out, say 20% or 30% of their disposable income just to pay off debt.

In the case of the other 3 cousins here, the ratio of Mariah should not be a cause of worry as it is 12% which can be managed easily. On the other hand, ratios of Melinda (20%) and Mariah (16%) are a bit on the higher side. If their incomes fluctuate or they face situations requiring them to make big expenses in the near future, they may start finding themselves in financially hard situations. So they should be careful to stay away from taking any additional debt till, either their current debt is repaid or their disposable income rises substantially