The word "debt" tends to evoke negative connotations, what with all the cautionary tales about how people and businesses who took on too much debt eventually went bankrupt. However, if it's handled correctly, debt might be beneficial.

Acquire Valuable Assets

Taking on debt allows businesses to expand and enable individuals to invest in long-term growth by purchasing assets like a home that might otherwise be out of reach. The interest rate applied to that debt is a further factor in how much you owe. Debt becomes manageable when the interest rate is reasonable, as with mortgages. However, credit card interest rates and other forms of high-interest borrowing can easily send debt levels spiralling out of control.

Behaviours Towards Expenditures And Investments

This doesn't mean people should always be taking on new debt. As with other things, the optimal level of debt is manageable and does not exceed one's resources. What constitutes an acceptable level of debt is contextually dependent on a wide range of variables, including but not limited to one's life stage, spending and saving habits, job security, career possibilities, financial commitments, and so on. For the sake of argument, let's pretend you're in a secure job, don't have any particularly expensive hobbies, and are looking to buy a home.

After-Tax Take-Home

To keep your debt load under control, a household may refer to the so-called 28/36 rule. A household's housing costs should not exceed 28% of its gross income, and debt payments should not exceed 36% of its revenue, according to the 28/36 rule. This rule of thumb considers gross income; a more frugal approach would be to use net income.

The 28/36 Rule

The 28/36 rule is a useful guideline for determining a manageable level of debt. As a general guideline, this rule states that a family shouldn't spend more than 28% of their annual gross income on housing costs.

All costs related to a home are included here, such as the mortgage, insurance, taxes, and homeowners association (HOA) dues. Total debt service, including mortgage payments, other loans, and credit card balances, should be at most 36% of a family's income.

The Cost of Servicing Debt

According to the 28/36 rule, a person who earns $50,000 yearly should spend at most $1,167 monthly on housing. It would be best if you didn't have to pay more than $4,000 a year, or $333 a month, to service your other personal debt.

With these assumptions, the maximum amount of mortgage debt you might take on is around $188,500 for a 30-year fixed-rate mortgage at 4% interest and a full monthly mortgage payment of $900 (leaving $267, or $1,167 minus $900, monthly for insurance, property taxes, and other housing expenditures).

Manageable debt Load

You can afford a new automobile payment of roughly $17,500 (assuming a 5% interest rate on the car loan, repayable over five years) if you have no other debts and are fortunate to have no credit card debt.

In conclusion, a respectable amount of debt would be below the maximum barrier of $188,500 in home debt plus an additional $17,500 in other personal debt at a yearly income level of $50,000, or $4,167 each month (a car loan, in this instance).

The Difference Between Gross and Net Income

Because net income or take-home pay varies from jurisdiction to jurisdiction depending on the level of income tax and other paycheck deductions, financial institutions use gross income to compute debt ratios instead. However, take-home income, or the amount you earn after taxes and deductions, is the one that should guide your spending decisions.

Family Debt Each Month

Assuming a 25% reduction in gross income due to taxation and other deductions, as, in the preceding example, you would be left with $37,500 annually, or $3,125 each month. That leaves $875 per month for home-related debt and $250 for all other debt, for a total of $1,125 per month or $13,500 per year in debt.

As mentioned earlier, the debt assumes current interest rates, which are extremely low relative to historical norms. Since interest expenses would take up a bigger portion of the monthly loan payback amounts if mortgage debt and personal loans both had higher interest rates, the total amount of debt that could be serviced would decrease.

What It Comes Down To

When handled correctly, debt may be a helpful financial tool. The 28/36 rule is a good benchmark for estimating a manageable level of debt, yet ultimately only the individual can decide what is appropriate for them.