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Keeping your debt at a manageable level is one of the most critical factors when it comes to a good sound financial plan and future.
How can you tell when your debt amount is starting to become worrisome? Fortunately, there’s a way to estimate your indebtedness without waiting until you realize you can’t afford to repay your debt obligations or your credit score starts to fall which can be dire to your ability to obtain future credit. This is called your debt to income ratio.
What is the debt-to-income ratio?
This ratio compares your monthly debt expenses to your monthly gross income and this comes out as a percentage. To calculate your debt-to-income ratio, add up all the payments you make toward your debt during a month. That includes your monthly credit card payments, car loans, other debts (for example student loans , investment loans) and housing expenses ,either rent or the costs for your mortgage principal debt amount, plus the interest, property taxes and insurance and any homeowner association fees.
Your next step is to divide your monthly debt payments by your monthly gross income, your gross income before taxes are deducted, to get your ratio. (Multiply your ratio by 100 to get to a percentage)
For example, if you pay $300 on credit cards, $300 on car loans and $1,200 in rent, your total monthly debt commitment is $1,800. If you make $50,000 a year, your monthly gross income is $78,000 divided by 12 months, or $6,500. Your debt-to-income ratio is $1,800 divided by $6,500, which works out to 0.27, or 27%
Banks research how much debt a client can take on before they are likely to start having financial difficulties, and they use this knowledge to set lending amounts and interest rates. While an average maximum debt to income ratio varies from lender to lender, it’s average is usually around 36%.
How to lower your debt-to-income ratio
If your debt-to-income ratio is higher than 36%, you may want to consider taking steps to bring this number down. To do so, you could do the following:
Recalculate your debt-to-income ratio on a monthly basis to see if you’re making progress.
Keeping up to date with your debt to income ratio can help you stay motivated to keep your debt manageable and below the 36% “danger zone”
Keeping your debt-to-income ratio below this “danger zone” will help ensure that you can afford your debt repayments and give you peace of mind that you are handling your finances in a mature manner. It can also aid you in being more eligible for future credit or for loans.