Why You Should Keep a Manageable Debt Load
Most consumers know what a credit score represents- it basically measures your credit worthiness so that lenders can determine whether to approve you for additional credit and if so, how much. But many people might be surprised to learn that your credit score doesn't even consider your income. It only predicts how likely you are to make payments based on your current level of debt and your past payment history.
Your debt-to-income ratio (DTI) gives you a fairly clear assessment of how high your debt level is when compared to your income. A low DTI is a good indication of sound financial health and should always be your ultimate goal.
What exactly is a debt-to-income ratio?In simple terms, the debt-to-income ratio compares your overall monthly expenses to your gross monthly income. Determining your personal DTI ratio is not difficult. You just need to calculate all of the payments you make every month to service your outstanding debt. For many people these would include the following expenses:
- Minimum credit card payments.
- Housing costs (either rent or mortgage), interest, property taxes, insurance, and homeowner association fees, if applicable.
- Car loan(s).
- Any other debts such as personal loans or payday loans.
- Student loans.
- Child support/alimony payments.
- Car loan - $355
- Mortgage - $950
- Minimum credit card payments - $235
John's total monthly debt payments add up to $1540.Once you have calculated your monthly debt payments, you need to determine your yearly income. This will most likely include:
- Gross income
- Any other income
- Child support/alimony
When you have the total amount of income earned, divide it by 12 to arrive at your monthly income.Again, let's take John as an example. He spends $1540 a month on debt payments. His annual income is:
- Gross income- $42,000
- Child support- $6,000
Therefore, John's total gross income is $48,000. To arrive at his monthly income you simply divide this total by 12. His monthly income is $4000.
Now you have the total amount of your debt payments each month and your total gross monthly income. To calculate your DTI ratio, you simply divide your monthly debt payments by your monthly income. Next, you multiply this result by 100.
Here's an example. Using John's calculations, his debt payments each month total $1540 and his monthly income is $4000. So $1540/$4000= .385 x 100 = 38.5%. John's DTI ratio is 38.5%.
The importance of your DTI ratio.Bankers and other lenders study an individual's credit score and calculate the DTI ratio when considering whether or not to approve new or additional credit. The following categories aren't written in stone, but they can give you a good indication of the state of your own personal financial health.
- 36% or less. This is usually considered the safest debt load for most people.
- 37%-42%. If your ratio falls within these ranges, you should concentrate on reducing your debt now.
- 43%-49%. This category generally indicates some financial problems. Start immediately reducing your outstanding debt.
- 50% or more. The bells and whistles should be going off if you fall into this DTI ratio category. This suggests a very dangerous financial situation. You should be paying off your debts as aggressively as possible. Seek professional help if you can't go it alone. Certified credit counselors can help you get back on track.
What you can do to reduce your DTI ratio.No matter what your personal DTI ratio is, the financially smart move is to try to keep it as low as possible. Here are some ideas on how to reduce your outstanding debt and improve your credit worthiness.
- Don't take on more debt. Put away the credit cards and don't apply for any new loans or credit.
- Make bigger payments to service your debts. This is one of the best ways to reduce your debt quickly.
- Don't make large purchases. Postpone or delay big-ticket items until your debt is at a reasonable level.
- Increase your savings. It's always good to have a savings account to rely on for emergency financial situations. This allows you to pay for unexpected expenses without taking on more debt.
- Check your DTI ratio every month. Keeping a close watch on your DTI ratio is recommended for several reasons. One, it keeps you focused on the big “prize” (paying off your debt) and secondly it allows you to see your progress and stay motivated.