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Understanding your debt-to-income ratio

debt-to-income ratio

Have you ever applied for a loan and been told that your debt-to-income ratio was too high? You may have wondered what that meant. Your debt-to-income ratio is the portion of your income that goes to debt payment, and it is a key component of creditworthiness. Lenders consider debt-to-income ratio along with credit score when deciding when to approve a loan.

Your debt-to-income ratio is calculated by dividing all your monthly debts by your gross monthly income. It does not include payments for utilities or insurance bills. For example, let’s say you have the following financial scenario:

Gross monthly income$3,800
Monthly debt payments
Car payment$325
Credit card payment (minimum)$50
mortgage payment$900
Student loan payment (not deferred)$200
Total monthly debt payments$1,475
Debt-to-income ratio39%

 

In this scenario, the debt to income ratio is 39% ($1,475/$3,800.

Many lenders prefer a debt-to-income ratio below 36%. They look at debt-to-income ratio as an indicator of your ability to repay your debt. A low debt-to-income ratio means you make a lot more money than you owe, and are seen as likely to have the resources to pay back the loan. If it is too high, you are seen as having too much debt in relation to your income, and are likely to fall behind on your payments and possibly default on the loan.

Is your debt-to-income ratio too high?

If your debt-to-income ratio is higher than 36%, consider these two things to increase your creditworthiness.

  • Reduce your monthly debt payment load. Paying off a credit card balance is probably the easiest. If you have a car loan with a low balance, that is another easy debt to eliminate. Consolidate debt into one loan, and lower the payment. Finally, avoid taking on any new debt until you can reduce what you owe.
  • Increase your gross monthly income. Get a second job or discover other ways to capitalize on your skills. You can also ask for a raise, or even find a better paying job. Make sure you include your spouse’s income if your debts are joint.

Managing your debt-to-income ratio, is one of the many things you can do to increase your personal financial stability and a secure future.

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