Debt to Income Ratio

There is a pretty easy way to get a real picture of your current financial situation. All you need to do is calculate your debt-to-income ratio. Simplistically, a debt-to-income (DTI) ratio compares the amount of your income used to pay debt. Mortgage lenders use debt ratios to help determine if an applicant will be able to repay a loan.

What is a debt-to-income ratio?

Debt-to-income ratios are widely used to measure financial stability. Your debt-to-income ratio is the percentage of monthly income that can be applied toward monthly long-term debt obligations. It is easy to calculate your debt-to-income ratio; divide the total amount of your monthly minimum debt payments (excluding mortgage or rent payments) by the total of your monthly gross income. For example, if your gross monthly income is $3000, and you are making minimum monthly payments totally $600 on loans and credit cards, your debt-to-income ratio is 20% ($600 / $3000 = .20). Remember, your gross income is what you make before any deductions.

Debt-to Income Ratio = Total Debt Payments / Monthly Gross Income

There are more complicated formulas for calculating debt-to-income ratios, and some experts may define a debt-to-income ratio slightly differently, the general idea is the same: a debt-to-income ratio compares debt obligations to income.

How to Calculate Your Debt-to-Income Ratio

Income

The first step in calculating your debt-to-income ratio is figuring your gross monthly pay, which is the amount you earn before all deductions. If you're paid every week, multiply your gross weekly pay by 52, then divide by 12 to get your gross monthly income. If your income is inconsistent and your income has not increased or decreased significantly since last year, estimate your gross monthly pay by dividing last year's annual pay by 12.

Remember to include:

• Regular income from alimony and child support can be counted as income
• Conservative averages of bonuses, commissions and tips
• Earnings from dividends and interest
• Miscellaneous income such as government benefits and/or assistance

Debt Payments

The second step in calculating your debt-to-income ratio is to figure your total monthly debt payments. Add your current minimum monthly payments for all credit accounts and loans, excluding mortgage or rent payments.

Be sure to include:

• Car payments
• Credit card payments
• Student loan payment(s)
• Payments on installment loans (furniture, appliances, etc.)
• Payments on personal loans (signature loan, etc.)
• Payment for past medical care

What is an acceptable debt-to-income ratio?

Generally, the lower your debt-to-income ratio, the better condition you are in financially. A debt-to-income ratio that is less than 15% allows you to better handle emergency expenses and save regularly. A ratio of 20% or higher is an indicator that you need to carefully control credit, evaluate your situation, and implement a plan to strengthen your financial stability. The ideal financial situation is to carry little or no debt so that you can save, invest, or spend your income on something other than debt and the interest it will cost you.

Your debt-to-income ratio

• 20% or less: This is considered a healthy debt load for most people to carry without causing financial overextension or stress.
• 20%-35%: You probably should scale down on your debt to avoid real financial problems. Look carefully at your monthly payments and expenses; start decreasing your total level of debt.
• 35%-50%: Financial troubles are looming unless you take immediate action. Stop accruing debt and decrease your total debt level.
• 50% or more: Get professional help to aggressively reduce debt

Why is monitoring your debt-to-income ratio important?

Being aware of your debt-to-income ratio helps you keep debt from creeping up on you. You can better manage your personal finances if you know your DTI, and keeping it less than 20% will help you steer clear of major credit problems.

Your DTI is a powerful indicator of your financial situation, and lenders look at your debt-to-income ratio when they consider extending credit. A high debt-to-income ratio rise will endanger your ability to get credit in order to make major purchases, such as a car or a home. You will also find it difficult to get additional credit in case of emergencies. If you keep your debt-to-income ratio low, you will more likely qualify for the lowest interest rates and best terms when you apply for credit.

.It is important to remember that your DTI is based on gross income. You still need to consider your net pay (take-home pay after deductions) before you take on more debt.