How much money do you make in a month? How much do you spend towards paying off your debts; including loans and credit cards? This defines your debt-to-income ratio. It’s simply calculated by adding up your monthly debt payments, including credit cards and loans, and then dividing that number by your monthly income. Multiply the result by 100 to get a percentage.
Your debt-to-income ratio indicates the percentage of your income that goes toward paying your debt each month. The lower your debt-to-income ratio, the better because it means you don’t spend much of your income paying debts. On the other hand, a high ratio means more of your income is spent on debt, leaving you with less money to spend on other bills or save.
Impact of a High Debt-To-Income Ratio
If your debt-to-income ratio is more than 50%, you definitely have too much debt. That means you’re spending at least half your monthly income on debt. Between 37% and 49% isn’t terrible, but those are still some high numbers. Ideally, it should be less than 36%. That means you have a manageable debt load and money left over after making your monthly debt payments.
A high ratio can have a negative impact on your finances in multiple areas. First, you may struggle to pay bills because so much of your monthly income is going toward debt payments. Also, you will find it tough getting approved for loans, especially a mortgage or auto loan. High debt payments are often a sign that a borrower would miss payments or default on the loan.
While your credit score isn’t directly impacted by a high debt-to-income ratio, some of the factors that contribute to a high ratio could also hurt your credit score.
How to Reduce Your Ratio
Generally, there are two ways to lower your debt-to-income ratio. First, you can increase your income. That could mean working some overtime, asking for a salary increase, taking on a part-time job, starting a business, or generating money from a hobby. The more you can increase your monthly income (without simultaneously raising your debt payments) the lower your ratio will be.
The second way to lower your ratio is to pay off your debt. While you’re in debt repayment mode, your debt-to-income ratio will temporarily increase because you’re spending more of your monthly income on debt payments. That’s because a higher percentage of your income will be going toward debt. But, when you’ve paid the debt all the way off, your ratio would drop to 0% because you’d no longer spend your income on debt.