Calculating debt-to-Income ratio ratio is an exercise you can easily add to your money management tasks. It is a good way to keep track of your financial health.
Why calculate debt-to-Income ratio?
If you are planning a large purchase that requires financing, such as a home, you need to be qualified by a lender. One metric that is used is the debt-to-Income ratio. This measures your ability to make your monthly loan payments.
Debt-to-Income ratio is the percentage of your gross monthly income that is allocated toward your monthly debt.
If your ratio is too high that means that most of your monthly gross income is allocated to your debts. In this case, the lender considers you a high risk and may not want to offer you the loan.
On the other hand, if your ratio is low, the lender determines that you are likely to make your monthly loan payments. Therefore, increasing the probability of loan approval.
Calculating debt-to-Income ratio
Add up all of your monthly debts and divide that number by your gross monthly income.
Your debts include mortgage or rent, car payments, student loan payments, minimum payments on credit cards, and any other personal loan payments. You do not need to include general living expenses such as utilities, food, gas, etc in this calculation. Add up your numbers and that is your monthly debt payment.
Your gross monthly income is your income before taxes and any other deductions. It is not the amount that you receive on your paycheck (net income).
If your income is irregular , the lender will likely ask you for income history over a period of one to two years so they can calculate an average. You can do this yourself too. Add up all of your income for a one year period and divide by twelve to determine your average. Better yet, add up for two years and divide by twenty-four.
Now that you have your total monthly debt payment and your gross monthly income you can calculate your debt-to-Income ratio. Divide your monthly debt by your gross income and you will get a percentage.
In the above example the total monthly debt is $2650 and the gross monthly income is $6000. Dividing 2650 by 6000 gives 44.17% for the debt to income ratio.
What is a good debt-to-Income ratio?
Now that you know how to calculate debt to income ratio you are probably curious what the numbers mean.
A lender likes to see a debt to income ratio that is less than 36%. They may accept one as high as 43%, but lower is always better. The lower your ratio, the less risk you are in the eyes of the lender.
In the above example, the ratio is high and it would be unlikely the lender will approve your loan. Granted, there are a lot of other things lenders take into consideration but this will be a red flag.
A high debt to income ratio means that it is time to clean up some of that debt before applying for a loan.
Improve your debt-to-Income ratio
There are only two ways to improve your ratio. You either earn more money or you reduce your debt. Ideally, you do both!`
Let’s talk about reducing debt. Write down all of your loan balances and order them smallest balance to largest. Review and adjust your monthly budgets. Focus on paying off the smallest balance first. Don’t worry about the interest rate. Once that first debt is paid off it will reduce the monthly minimum payment on your debt to income ratio calculation. It will also give you more money to allocate to the next debt.
Let’s assume that in the above example, the debt balances are as follows:
Since credit cards are the lowest amount owed, tackle those first. Do everything you can to pay that $5000 off. Once your credit cards are paid off you know longer have the $550 per month listed in your monthly debt portion of your calculation. See below
Now your debt to income ratio is 35%, which is a much healthier ratio.
Summary
Calculating debt-to-Income ratio regularly will help you stay on top of your financial health and understand your borrowing power.
The bottom line is to reduce your monthly debt and increase your income. Although I stress debt free living, there are just some things you will need to borrow funds for.
However, when you do, just be careful and do not overextend. Add to your plan to repay that loan as quickly as you can and you will still be in control of your money.
You can track your debt-to-Income ratio using a spreadsheet, paper and pen or online calculators.
Whatever tool you use, be sure to plug in different values (“what if” scenarios) to see which debt payoff strategy would have the most positive affect on your debt to income ratio.
If you have any questions, please reach out. I am happy to help.
Thanks for reading!
Stay balanced,
Jill