Why Is Your Debt To Income Ratio Important?
Could your debt be affecting your credit? Here’s how to tell if your debt is out of proportion to your income.
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? Fortunately, there’s a way to estimate if you have too much debt without waiting until you realize you can’t afford your monthly payments or your credit score starts slipping.
What is debt-to-income ratio?
Your debt-to-income (DTI) is a ratio that compares your monthly debt expenses to your monthly gross income. To calculate your debt-to-income ratio, add up all the payments you make toward your debt during an average month. That includes your monthly credit card payments, car loans, other debts (for example, payday loans or investment loans) and housing expenses—either rent or the costs for your mortgage principal, plus interest, property taxes and insurance (PITI) and any homeowner association fees.
Next, divide your monthly debt payments by your monthly gross income—your income before taxes are deducted—to get your ratio. (Your ratio is often multiplied by 100 to show it as a percentage.)
For example, if you pay $400 on credit cards, $200 on car loans and $1,400 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, or $5,000. Your debt-to-income ratio is $2,000 divided by $5,000, which works out to 0.4, or 40 percent.
How to calculate your DTI
Why is my debt-to-income ratio important?
Banks and other lenders study how much debt their customers can take on before those customers are likely to start having financial difficulties, and they use this knowledge to set lending amounts. While the preferred maximum DTI varies from lender to lender, it’s often around 36 percent.
How to lower your debt-to-income ratio
If your debt-to-income ratio is close to or higher than 36 percent, you may want to take steps to reduce it. To do so, you could:
- Increase the amount you pay monthly toward your debt. Extra payments can help lower your overall debt more quickly.
- Avoid taking on more debt. Consider reducing the amount you charge on your credit cards, and try to postpone applying for additional loans.
- Postpone large purchases so you’re using less credit. More time to save means you can make a larger down payment. You’ll have to fund less of the purchase with credit, which can help keep your debt-to-income ratio low.
- Recalculate your debt-to-income ratio monthly to see if you’re making progress. Watching your DTI fall can help you stay motivated to keep your debt manageable.
Keeping your debt-to-income ratio low will help ensure that you can afford your debt repayments and give you the peace of mind that comes from handling your finances responsibly. It can also help you be more likely to qualify for credit for the things you really want in the future.