Debt to Income Ratio: What You Need to Know
What is debt to income ratio? When was the last time you checked on your debt to income ratio? Credit card companies have made it easy to get approved for new credit cards and accumulate debts without thinking about it.
Maybe you went through a rough patch and had to use credit to get you thru. Maye that new car is making it hard to stay on top of your bills at the end of the month.
Whether you are about to make a big purchase, like applying for a mortgage or a car loan, or not, it is always a good idea to calculate your debt to income ratio on a regular basis as it is an important indicator of your financial health and a sharp tool on how to pay your debt fast.
What is your debt-to-income ratio?
Your debt to income ratio is the percentage of your budget, before taxes and other deductions are taken out, that is allocated to debt repayment.
It is calculated according to the following formula:
[Total Debt Payments] ÷ [Gross Income]) x 100 = [Debt to Income Ratio]
This ratio helps potential lenders determine whether you are a good candidate for a new loan or mortgage or not. However, a high debt-to-income ratio is also a sign that you are spending too much money on debt rather than on other posts including saving.
This could potentially mean that you would be vulnerable if something unexpected happened, like losing your job, finding yourself in an accident, or simply having to deal with significant home repairs like your furnace breaking down in the middle of the winter.
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Depending on your personal situation, your debt could be small to extremely important.
The average American carries $38,000 in personal debt reduction and $580 on monthly debt payments not including mortgages or auto loans, while less than 23% say that they do not carry any debt according to a Northwestern Mutual’s 2018 Planning & Progress Study.
This amount includes anything from credit card debt, to student loans, from medical debt to car payments.
Having financial reserves is a significant element of your financial health and should not be put in jeopardy by debt repayment.
A good rule of thumb is to put 25% of your overall gross salary, yet most American adults have less than $1,000 in their savings account and no retirement plan.
How Much is Too Much Credit Card Debt?
A low debt-to-income ratio will show potential lenders that your income is sufficient to repay any outstanding debt in a timely manner.
Most lenders will not consider you a good potential borrower if your debt-to-income ratio is higher than 50%. If it is below 36%, most creditors will consider you have a good candidate for a new line of equity.
Anywhere between 37% and 49% will raise red flags for potential creditors, but most will lend to you: 43% is often considered the threshold for a borrower to still meet the requirements for a qualified mortgage according to the Consumer Financial Protection Bureau.
However, the lower the ratio is, the most likely you are to get more favorable lending conditions, such as the size of the loan, lower interest rates, life of your potential loan and so on. All these elements could contribute to saving you thousands of dollars over the life of the loan.
Another thing to keep in mind while debt accumulates is that your debt-to-income ratio is one of the elements that is considered when calculating your credit profile and it accounts for 30% of your credit score. If your credit utilization is too high, it could be a sign that your credit score could deteriorate quickly.
Credit card debt could prove to be an adverse element: when calculating it, lenders only include the required minimum monthly payments you must make, not the larger amount you would have to make in order to pay off the debt more quickly.
What to Do if Your Debt-to-Income Ratio is Too High?
If, after calculating your debt-to-income ratio, you find it to be too high, there are several steps you can take to bring it down to more favorable levels.
Making minimum payments on your credit cards is not enough to get out of debt as it will take you years and will end up costing thousands of dollars in interest.
To lower your debt to income ratio, try paying more than your minimum payment. You can focus on one debt at the time, starting with the smallest one and using the newly liberated payment to add to the next one up: it is commonly known as the “snowball” repayment method.
You can also use this method by starting with the debt with the highest interest rate: it is the “waterfall method”.
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If making higher minimum payments is not an option, you can use one of your assets to borrow against.
It could mean taking a line of equity on your house or borrowing from your life insurance or your 401(k). You will still have to repay that debt, but the interest rates are typically lower than credit cards with high APR and could save you a significant amount of extra money in interests.
If you do not have any significant assets, different agencies can help you reduce your debt. However, these options might affect your credit in the long run.
A credit counseling agency will help you set up a debt management plan within your budget that will help you pay off your debt within 3 to 5 years.
One thing to keep in mind before choosing this solution is that you will not be able to use your credit cards or open a new line of credit during that time period. Your credit score will not be affected. If your credit score is good enough, you can consolidate your debt by using a debt consolidation loan to repay unsecured debt.
If you are behind on your payments, debt negotiation or debt settlement could be an option for you: enrolling with a debt payment agency will significantly reduce your debt-to-income ratio, but it will also severely affect your credit score.
Finally, if your debt is too overwhelming, you might need to file for bankruptcy.
Overall, your debt-to-income ratio is a crucial element when it comes to your financial health and you should aim to keep it as low as possible.
Published January 18, 2019; UPDATED August 6, 2019.