While debt to income ratio might sound like a metric more suited to accountants and financial professionals, your personal debt to income ratio is something that you should know and track. For starters, financial institutions use debt to income ratio in determining whether to grant you credit, including loans for mortgages. Additionally, debt to income ratio is a strong indicator of your overall financial position.
If you’re wondering how to calculate debt to income ratio, it’s actually quite simple. Divide all of your recurring monthly debt by your gross monthly income. For example, if you have $1,000 in monthly debt across your credit cards, car payment, mortgage, and other types of debt, and $2,900 in gross monthly income before taxes, your formula would look like this: 1,000 / 2,900 = 34%.
What is a good debt to income ratio? For most purposes, a debt to income ratio should be no more than 36%. It is not uncommon for your debt to income ratio to change as you take on new debt and pay off old debt, but in general, an acceptable debt to income ratio would usually fall below 36%.
How to Lower Your Debt to Income Ratio
If you do the calculations and find that your debt to income ratio is above 36%, learning how to lower debt to income ratio should be a priority. A high debt to income ratio not only impacts creditworthiness, but can also lead to stress when you are in over your head with debt.
There are two ways to reduce your debt to income ratio: Either reduce your debt, or increase your income. Of the two, reducing your debt is usually the more realistic means to lower your debt to income ratio. Here are a few methods you can use to accomplish this while learning how to reduce debt to income ratio:
- Avoid the temptation to accumulate more debt by removing yourself from the mailing lists that send you attractive credit offers. Learn how you can do this with Stumble Forward’s article on stopping junk mail once and for all.
- Control your debt and make better use of your income by prioritizing repairs to your home, car, and other possessions. Repair bills tend to escalate as problems with these big-ticket items tend to spread. Learn how to prioritize by performing yearly home maintenance and minimize further debt accumulation.
- Increase the monthly amount you are paying on your debts. As Bank of America points out, extra payments are applied to principle, which reduces your debt and prevents further interest accumulation more quickly.
Your Debt to Income Ratio and Mortgages
If you are preparing to apply for a mortgage, whether it’s a new primary mortgage or a second mortgage on your existing home, your debt to income ratio may be a critical factor in your loan’s approval. If you have a high debt to income ratio, you should start working on lowering it well before you anticipate applying for a mortgage.
But what is the debt to income ratio for mortgages? According to LendingTree, there are no hard and fast rules, but most lenders prefer to see a debt to income ratio below 36%. Additionally, your household expenses that are not debt – for example, utilities, groceries, and transportation costs – should not exceed 28% of your gross monthly income. Yet there are exceptions, notably with Federal Housing Authority and Veterans Administration backed mortgages, which may allow debt to income ratios of up to 41%.
Make it a New Year’s resolution to calculate your debt to income ratio by collecting your monthly debt costs and calculating your gross monthly income. If your debt to income ratio is close to or above 36%, it might be a good idea to focus on reducing it in the New Year. On the other hand, if your debt to income ratio is below 36%, you now have the motivation and knowledge you need to keep your debt to income ratio healthy.