Your debt-to-income ratio offers a way to easily assess the state of your finances. The ratio compares your total monthly debt (not including your rent or mortgage payment each month) to your total monthly income. A debt-to-income ratio that is less than 20% is considered to be a good number. Effectively, this indicates you are financially stable.
When your ratio is more than 20%, it means that you have too much debt relative to your income. As as a result, creditors may be unwilling to offer you attractive terms on a new loan or line of credit; you may even struggle to get approved at all. If you do get approved, it will cost more to use credit with interest added and assets like a new home or a car may be out of your financial reach. If your ratio is greater than 20% eliminating debt will lower the ratio and make you more appealing to creditors and lenders.
Calculating your debt-to-income ratio is not difficult. Here's how:
- Using your budget, add up all sources of your monthly household income, including income from work, tips and commissions, any alimony or child support you receive, rental income, government benefits and so on. If your spouse works outside the home or receives income from other sources, include that too and come up with your household's Total Monthly Income. (As you factor in income from a job, make sure to use your net income, which is the pay you actually bring home each month.)
- Next refer to your budget to total up your monthly debt payments.Your calculations should be based on the minimum payments due for each debt, so if you pay more than your minimums, refer to your credit card statements for the current payment requirement. Make sure not to overlook any of your debts, except for your mortgage or rent which should not be included in your ratio. The total calculated is your Total Monthly Debt.
- Divide your Total Monthly Debt by your Total Monthly Income. The result will be a percentage; this is your debt-to-income ratio.
Upsides to a Low Debt-to-Income Ratio
- Appeals to new creditors and lenders
- Indicates financial stability
- Allows you to build savings
Downsides to a High Debt-to-Income Ratio
- There is little-to-no money left in your budget for savings
- Increases your chances to experience financial distress
If your debt-to-income ratio is over the recommended percentage (20%) and you do not reduce your debt load, increase your income or both, then you are likely to fall deeper into debt and may experience financial hardship. You need to pay down debt as quickly as possible so you can become more attractive to creditors. That way you can qualify for the best available interest rates and terms on new loans and lines of credit.
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