Have you ever wondered how much debt is too much, or how much would be ‘normal’ for you to sustain while living on an income? The answer to that question lies in another question, i.e., 'How much debt can you afford?’ Many people, especially those with a fixed income, often encounter a debt-lock situation. These can be spurred by multiple factors from irresponsible borrowing to lack of financial planning. With the help of financial experts let’s examine indicators that show you are on the path to a debt trap:
Advertisement
What are the key financial indicators that suggest you are taking on too much debt?
If you survive on a fixed salary and have to take credits for extra spending, the bane of your financial stability is mostly those EMIs.
EMI/Total In Hand Income: ‘When your EMI’s as a proportion of your monthly income crosses 50% is usually a clear warning sign that debt is piling up,’ says Naresh Bulchandani, CFA (Merisis Wealth).
Total Fixed Obligations(TFO)/Total In Hand Income: When your TFO as a proportion of your monthly income crosses 70 per cent, it is another early warning signal that one may be entering a debt trap.
Advertisement
(Fixed obligations include all your fixed financial commitments or requirements such as EMIs, insurance premiums, and other regular payments).
High Refinancing Ratio: If you constantly need to refinance your loan outstanding by taking on another loan, it’s an indication that you are facing difficulty servicing your current outstanding commitments from a fixed monthly income stream.
A Low Credit Score: Failing to settle your credit card bills in full is a significant sign of moving towards a debt-trap situation. “People with high levels of debt will have a poor debt servicing track record which ultimately affects their credit score,” Bulchandani says.
How to calculate your debt-to-income ratio?
Debt to Income ratio can be calculated by totalling up all the EMI and then dividing the same by monthly income to arrive at a % value. “One should target to keep this ratio between 20 per cent to 35 per cent,” says Abhishek Kumar, Sebi RIA (SahajMoney).
What would a healthy debt-to-income ratio be?
When an individual is considering taking a large loan, say for example, a housing loan, it is important to divide the monthly EMI by the monthly income credited to their bank account (as this income is after statutory deductions like taxes).
Advertisement
“Generally, a range of 40-50 per cent is deemed to be an acceptable range. It is also important to consider other ongoing EMIs while calculating your Debt-to-Income Ratio and deduct the existing EMIs from the monthly income before calculating the ratio for the fresh loan,” Bulchandani explains.
Early warning signs to show your debt levels are becoming unmanageable:
Not being able to manage your EMIs while regularly finding ways to arrange funds to pay for them is an early sign that your debts are getting out of control. This could be things like regularly dipping into savings to pay EMI or making minimum payments on Credit Card loans. “Instead of this one should wake up and smell the coffee and work towards finding ways to deleverage or reduce their debt to a manageable level,” Kumar suggests.