A widely used measure for gauging financial stability is called a debt-to-income ratio. Because it is such a powerful indicator, lenders look at this ratio when they consider extending credit. A high debt-to-income ratio jeopardizes chances of making major purchases, such as a car or a home. Maintaining a low debt-to-income ratio, along with a good credit history, will help you to qualify for the lowest interest rates and best terms.
How to Calculate Your Debt-to-Income Ratio
The debt-to-income ratio is represented as a percentage. There are two methods of determining debt-to-income ratios. The first method is to compare net monthly income vs. debt. The second, and more widely used method, compares gross monthly income vs. debt. For the purposes of this section we will be referencing the second method.
The first step in calculating your debt-to-income ratio is to assess your gross (before taxes) monthly income. Some people have additional income besides their pay.
Some examples of additional income are:
- Regular income from alimony and child support.
- Bonuses, commissions and tips (approximate values.)
- Dividends and interest earnings.
- Government benefits and/or assistance.
Next, list the current minimum payments on all credit cards and loans (except mortgage).
Be sure to include:
- Car payments
- Installment loan payments
- Bank/credit union loans
- Student loan payments
- Credit lines
Debt-to-Income Ratio is calcultaed as the total debt payments divided by the gross monthly income. For example:
Total debt payments = $700
Gross monthly income = $3,200
Debt-to-Income Ratio= $700 / $3,200 = 22%
What Is An Acceptabel Debt-to-Income Ratio?
Generally, the lower a debt-to-income ratio is, the better your financial condition. Following are examples of the different percentages. Note: This example assumes a loan applicant's FICO score is above 700.
10% or less: Shouldn't have trouble getting loans. May qualify for lower rates.
11% to 20%: Again, shouldn't have trouble getting loans. Time to scale back on spending.
21% to 35%: Although you may not have trouble getting new credit cards, you are spending too much of your monthly income on debt repayment.
36% to 50%: You may still qualify for certain loans, however it will be at higher rates. It is time to develop a plan to get out of debt.
More than 50%: Very difficult to qualify for financing.
Note: All answers are providing the consumers FICO score is above 700.
You can avoid going into debt by staying aware of your debt-to-income ratio. Knowing your debt-to-income ratio will help you to make sound decisions about making purchases on credit or taking out loans.
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