The financial world is, unsurprisingly, all about numbers. And as a consumer, there are a few numbers that can offer telling details about your financial health. Those include your net worth and your credit score.
Another on the list: Your debt-to-income ratio. Here's how to calculate this key figure, how it can affect your finances, and what you can do to improve it.
Your debt-to-income ratio is typically expressed as a percentage, and basically, it tells a lender how much of your monthly income is being used to pay down debt. That includes fixed payments for installment debts like student loans, auto loans, and mortgages, and minimum payments toward credit card balances.
Your total debt is less important for this ratio than how much of your monthly income those debt payments consume. "It's misleading," says Scott Colbert, chief economist at Missouri-based Commerce Trust Company. "It's not really about debt," but rather how much money you're spending every month paying it down.
Here's the formula to determine your debt-to-income ratio:
Debt-to-income ratio = (monthly debt payments / gross monthly income) x 100
To calculate your ratio, divide your total monthly debt payments by your gross monthly income, or how much you earn before taxes and other deductions are taken out. Multiply the result by 100 and you'll have the percentage of your income that goes toward debt repayment.
The smaller your ratio is, the better. That's because a lower ratio indicates you're spending less money on your debt every month, which is a good signal to a potential lender.
Typically, you'll want a score no higher than 45%, says Colbert. "When you approach 50%, you'll have a hard time getting credit anywhere."
"When you're applying for a mortgage, especially, the lender focuses on your debt-to-income ratio," says Colbert. Most mortgage lenders look for scores no higher than 36%, including that housing payment.
But be aware that your debt-to-income ratio isn't always a good gauge of how much you can afford to borrow, he says. Because lenders calculate using your pretax income rather than your take-home pay, your debt can look like a smaller commitment by comparison. If you're not careful, you could end up with a mortgage payment that strains your budget.
Either move is likely to take time. You may need to build a case for a raise or find a new job, for example. When it comes to debt repayment, you might benefit from using the snowball approach to tackle some small balances and eliminate a few of your required monthly payments.
Colbert says that because the formula takes into account your monthly debt obligations rather than overall debt, refinancing your debt to get a lower interest rate can be a smart move. Doing so may reduce your monthly payment, and in turn, your debt-to-income ratio. This can be especially helpful for long-term, sizable debts like mortgages, auto loans, or student loans.
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