Your debt-to-income ratio is a way to measure your financial health. Being in good standings with your financial health is very beneficial and critical to your ability to be granted credit or loan approval.
On a personal level, being healthy financially with a good debt-to-income ratio can help you plan for living a desirable lifestyle. If you have a low debt-to-income ratio, you are in a better position to handle your debt responsibility. With a low debt-to-income ratio, your lifestyle planning can easily include important things like family recreational activities, save for financial goals and save for retirement income. Think of how appreciable your family will be if your lifestyle plan includes family recreational activities such as weekend outings and memorable family vacations.
If you have a high debt-to-income ratio, you are in jeopardy of living a life filled with stress and worry. There is constant worry about paying bills on time, if paid at all. Or, the worry of having enough money to cover the debt and not have money left for other necessities such as groceries or gas for the month. Living this type of lifestyle is harmful as it causes damaging health issues as well as unbearable family dysfunction.
The debt-to-income ratio is used by creditors and lenders to determine the willingness to take a risk of granting or extending credit or approving an amount for a loan. With a lower ratio number, creditors or lenders believe there is a high probability for debt re-payment. With a higher ratio, creditors and lenders consider you as a risky borrower and lean towards declining the application request for fear of the inability to keep the promise of debt re-payment.
The debt-to-income ratio is scrutinized heavily during the mortgage qualification process. In general, a debt-to-income ratio at or below 36% is considered a good ratio for underwriting qualifications. For credit card approvals, each creditor varies in what they consider as the highest acceptable ratio. Once you reach 50% and higher, you can expect to receive a decline in a request for credit.
To calculate your debt-to-income ratio, you will need your total monthly debt and your gross (pre-tax) monthly income. Here’s the formula:
Debt-to-income = Total monthly debt / gross monthly income
For an example, let’s say you have a mortgage payment in the amount of $1500, a car payment of $350, and credit card payments of $150, your total debt payments equal $2000 a month. If your gross (pre-tax) monthly income is $6000, then your debt-to-income ratio is 33%. ($2000/$6000 = 33%).
To determine what amount of debt you should have to be in good standings with your financial health, such as a 36% debt-to-income ratio, multiply your gross (pre-tax) income by 36%. For example, with a gross income of $4000, the maximum monthly debt should be $1440 ($4000 x 36% = $1440).
To make sure you are calculating the ratio correctly, the following monthly debt payments should be considered:
In your calculation, do not include the following monthly expenses:
Utilities (water, electricity and gas)
If you are unsatisfied with your calculated debt-to-income ratio, there are two ways to change it. One, increase your income. This may include taking on a part-time job or using your skills to start a side business. Two, reduce your debt. Of course, reducing your debt can be a long and slow process. It takes creating a lifestyle plan that is sustainable and diligently working on the plan without let up. If you need help creating a workable lifestyle plan, contact me at 704-626-7484.