How understanding your debt-to-income ratio can help
Keeping your debt at a manageable level is one of the foundations of good financial health. But how can you tell when your debt is starting to get out of control? You don't want to wait until you can't afford your monthly payments or your credit score starts slipping. Fortunately, there is a way to estimate if you have too much debt.
What is debt-to-income ratio (DTI)?
The debt-to-income ratio (DTI) compares your monthly debt expenses to your monthly gross income. To calculate your debt-to-income ratio, first add up all the payments you make a month to service your debt. That includes your monthly credit card payments, car loans, other debts (payday loans, investment loans) and your housing expenses - either rent or the costs for your mortgage principle, interest, property taxes and insurance (PITI) and any homeowner association fees.
Next, divide your monthly debt repayments by your gross income per month (before taxes are deducted). Multiply that number by 100 to get your DTI as a percentage.
For example, if you pay $400 on credit cards, $200 on car loans and $1,400 a month in rent, your total monthly debt commitment is $2,000. If you make $60,000 a year, your monthly gross income is $60,000 divided by 12 months for a total of $5,000 a month. Your debt-to-income ratio is $2,000 divided by $5,000, which works out to .4 or 40%.
How lenders view your debt-to-income ratio
Once you know your DTI, you can quickly get a better idea of whether it's too high by understanding how lenders view it. Banks and other lenders study how much debt their customers can take on before they may start having financial difficulties, and use this knowledge to set lending amounts. The preferred maximum DTI varies from lender to lender, but it's often around 36%.
Reducing your debt-to-income ratio
Take another look at our example, and you'll see the DTI of 40% is rather high. If this was your situation and you decided to apply for a loan, you might have difficulty qualifying. Having too much debt can also lower your credit score, which means you may pay higher interest rates or not qualify for loans.
If your debt-to-income ratio is close to or higher than 36%, there are steps you can take to reduce it:
- Increase the amount you pay monthly to service your debts. Extra payments can be applied directly to the principle, lowering your overall debt more quickly.
- Avoid taking on more debt. You can do this by reducing how much you charge on your credit cards, and by not applying for loans.
- Postpone large purchases until you have more savings. If you make a larger down payment, you'll have to fund less of the purchase with credit, which will help keep your DTI low.
- Recalculate your debt-to-income ratio monthly to see if you are making progress. Watching your DTI ratio fall can help you stay motivated to keep your debt manageable.
Keeping your debt-to-income ratio low will help ensure you can afford your debt repayments and give you peace of mind that you can handle your financial responsibilities. It also means you're more likely to qualify for credit for the things you really want in the future - like a new home.
What's next? How to improve your credit score