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?
Debt-to-income (DTI) ratio is a measure of your ability to make your loan payments every month. It’s a snapshot that shows how much debt you carry relative to your income on a monthly basis.
When you apply for a loan, most lenders will evaluate your DTI ratio when deciding whether to extend you a loan. Deciding upon your “creditworthiness” is a matter of predicting future behaviour. Since recent past behaviour is the best predictor of future behaviour, lenders will look at your current and recent debt and income behaviours in order to predict how you will repay your future obligations to them.
How to Calculate Your Debt-to-Income Ratio?
The Debt-to-Income ratio formula looks like this -
Total monthly debt payments, divided by Gross Monthly Income and multiplied by 100.
Monthly debt payments include rent, home insurance and home loan payments, alimony or child support payments, credit card debt payments, student loan payments, auto loan payments and any other loan or debt payments. In general, though, you don’t want to count any monthly expenses such as groceries, gas, utilities, entertainment, life insurance premiums or personal taxes in your DTI ratio. Your gross monthly income is the income you make each month before taxes.
Debt-to-Income Ratio 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.
What is a Good Debt-to-Income Ratio?
The lower your debt-to-income ratio, the better. A lower DTI ratio shows a lender that you are less risky and more likely to pay back your loan each month. In general, a DTI ratio of 35% or less is considered good. This means that the amount of debt you have compared to your income is manageable.
How to Improve Your Debt-to-Income Ratio?
If you’re struggling to qualify for a personal loan, your debt-to-income (DTI) ratio could be one of the factors. Here are some financial tips that could help you improve your Debt-to-Income ratio:
- Increase your income
- Track your spending by creating a budget, and reduce unnecessary purchases to put more money toward paying down your debt.
- Lower your debts and financial obligations
- 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.
- Avoid taking on more debt. Consider reducing the amount you charge on your credit cards, and try to postpone applying for additional loans.
- Recalculate your debt-to-income ratio monthly to see if you’re making progress.
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.
