- Get Out of Debt
Your debt-to-income ratio is one of the most important numbers tied to your finances. As far as lenders are concerned, it’s not as important as your credit score, but it could still determine whether you get a mortgage or an auto loan and it can also tell you how far into the red you are and how likely you are to default.
But what is a debt-to-income ratio, how does it impact your chances of getting a loan, mortgage or credit card, and what does it mean for your financial future?
What is a Debt-to-Income Ratio?
Your debt-to-income ratio is a calculation that compares your monthly income to your monthly debt. Using a debt-to-income ratio calculator can give you an idea of where you stand, painting a clear picture of your personal finances. It can also tell a lender how likely you are to meet monthly debt payments.
There are two types of debt-to-income ratio. The first is known as Front-End and calculates how much of your income would go towards mortgage payments and housing expenses. The ideal percentage here is less than a third (28%) and essentially compares the state of your finances to the size of the mortgage payment.
If you have an income of $2,000, for instance, then it’s clear a mortgage payment of $1,000 would be excessive, while $560 or less would be ideal.
Typically, when this ratio is discussed it’s in reference to a Back-End ratio, which, as discussed above, compares all your debt against your income and provides lenders with more insight into your financial situation.
How to Calculate Your Debt-to-Income Ratio
To calculate this figure, simply add all of your monthly debt payments and divide them by your gross income:
- Income: Your gross income covers all earnings minus tax and other deductions, such as healthcare. You can also include income from investments.
- Debt: All your monthly debt obligations, from mortgage payments to credit card interest and student loan payments, need to be included.
As an example, let’s assume that your take-home pay (pre-tax income) is $5,000 a month and your debt is $2,000 ($1,000 for your mortgage payment, $500 to cover credit cards, and another $500 to cover additional monthly debt payments). Your ratio would then be 40%, as $2,000 (your debt) is 40% of $5,000 (your gross income).
Obviously, the lower this figure is, the better; the higher it is, the more issues you are likely to encounter when applying for a mortgage or other major loan.
What is Considered a Good Debt-to-Income Ratio?
The most commonly quoted figure is 43%, as this is said to be the highest ratio that an individual can have if they want a Qualified Mortgage. There are exceptions, but this is the standard and you should try to remain below it where possible.
In the above example, our monthly payments included a mortgage, which accounted for half of the recurring monthly debt. If we take that out of the picture, it begins to look a little easier, but only if you ignore the fact that the average American doesn’t earn anywhere near $6,000 a month and takes home less than $4,000 on average.
If we assume earnings of $3,500, which is much closer to the average, then it only takes a little student loan debt and credit card debt to skew the statistics. Add an auto loan or personal loan into the mix and it’s easy to see why someone might struggle to get below 50%, let alone 43%.
The good news is that it’s still possible to get new credit with a ratio higher than 43%. It will depend on the lender, however, and the higher it climbs, the less likely your chances are.
The Importance of a Debt-to-Income Ratio
This ratio tells a lender how likely you are to default. The greater your liabilities are compared to your earnings, the harder it becomes to acquire new credit because every additional credit card limit or loan reduces your cash flow and increases your risk.
These ratios can be misleading because they often look much better to the consumer than they do the lender—the former is only focusing on the short-term while the latter has the data to understand the long-term.
For example, if you have a score of 50% with $3,000 leftover every month, you may think you’re in a good position. After all, $3,000 is a lot of money and could cover three average mortgage payments. But then you have to consider food, clothing, and other necessities, and what happens when you’re hit with an unexpected bill?
The higher this ratio is, the closer you are to the edge and it doesn’t take much to knock you off. This is why you should focus on keeping your debt-to-income ratio as low as possible and avoid any new accounts that put you in dangerous territory.
How to Improve your Debt-to-Income Ratio
There are a few ways that you can improve your ratio, potentially improving your credit score at the same time:
- Debt Consolidation: As discussed in our guide to debt consolidation loans, this process isn’t straightforward and it doesn’t always work out for the best. But while a consolidated debt may cost you more in the long-term, it will also reduce your payments in the short-term, thus decreasing your debt-to-income ratio.
- Avoid New Debt: If you’re improving your ratio so you can get a mortgage in the future, you need to focus on the big picture and stop acquiring new debt. Forget about that new credit card, give the auto loan a miss, and try to survive on what you have.
- Pay More: Credit card debt can seriously affect your monthly payments and have a massive impact on your credit score and debt-to-income ratio. Most of the money you pay goes towards interest, but as soon as you meet those minimum payments, the rest will go towards the balance. So, pay more money each month and you’ll eradicate more of that balance each time.
- Ask for a Raise: It doesn’t hurt to try, and every cent extra you make per hour can have a major impact on your salary, thus improving your ratio.
- Work Part-Time: It’s easier said than done, but if you have the skills and some free time, then pick up some freelance work in your downtime. We’re living in the gig economy right now and it has never been easier to improve your gross monthly income by doing a spot of freelance writing, design or admin work.
- Use Savings and Investments: Your investments count towards your gross monthly income, but you may benefit more by using them to clear some of your debt. Run the sums, see how much you’ll save and how many debts you can clear, and cash those investments in. The same goes for savings, if you have a lot of debt then there’s a high chance you’re losing more in interest than you’re gaining in savings.
How Long Will it Take?
Take it month by month and be prepared to stay in it for the long haul as it’s not something that happens overnight. If you have relatively good credit, have been at your job many years and have numerous skills, you can make it work relatively quickly.
In a single week, you can push to clear some of your debts, ask for a raise, and start applying to some freelance projects. By the end of the month, you can make some serious headway on improving your ratio. If not, it will take you a little longer to make any notable improvements, possibly up to 6 months, but every month that your wages stay the same and you meet your minimum payments is a month closer to your goal.
If you’re trying to improve your score so you can get a mortgage, then focus on the bigger picture and remind yourself that a little dedication is all it takes and within 6 months you could have the mortgage you need and the house you want.
Should it be Prioritized?
It all depends on what your goal is. Your debt-to-income ratio is not something that has a direct impact on your credit score. Indirectly, it can affect certain key areas, but your credit score doesn’t factor this ratio into the equation.
To improve your credit score, therefore, you should be focusing more on payment history and credit utilization, which calculates total debt vs available credit as opposed to debt vs gross monthly income.
If you want to get a mortgage and you have a debt-to-income ratio that puts you out of the ideal range, this should be your main focus. In any case, the things you do to benefit your debt-to-income ratio can also benefit your credit score and vice versa. Nothing you can do to improve one will hurt the other, so there’s no reason why you can’t seek to improve your credit score and your debt-to-income ratio at the same time.
Conclusion: Ratios and Scores
Credit card companies, mortgage companies, and other lenders will factor many things into the equation when looking at new applicants. They process a lot of data because this tells them how likely an individual is to default, and whether or not they are worth taking a risk on. The best borrowers get low-interest rates and all the loans they want, the worst either get rejected or are forced to take high-interest offers that will only make their situation worse.
It’s a bit of a Catch-22, but if you calculate your debt-to-income ratio it will help you as much as it will help a lender. It will give you an idea of where you stand, where you’re likely to be in months and years to come, and if you need to make any drastic lifestyle changes or not.
It’s easy to blind yourself to the real issues and pretend that everything is fine and dandy even as the dikes are preparing to burst. By biting the bullet, facing the truth and calculating your score, you can take necessary measures to prevent personal financial disaster and create the sort of profile that lenders want to see.
Source: pocketyourdollars.com