It is important to spend less money than you earn, if you want to stay out of debt. But this can be more difficult than it seems. Your debt to income ratio is an important part of your overall credit history. But if you’re unable to control your spending and spend more money than you earn, your debt to income ratio will be high, making it hard to finance a home or make major purchases.
Factors Used to Calculate Debt to Income Ratio
Two basic factors are used to calculate your debt to income ratio, your net worth and your total debt. The credit industry has standard guidelines to determine if your debt to income ratio is too high. The standard may be a bit low due to the fact that many have an acceptable debt to income ratio but still struggle to pay monthly expenses.
Net Worth and Total Debt
Your total net worth will include your monthly net pay, including overtime and bonuses, and any other annual income, whereas the total debt will include your mortgage, other loan payments or revolving accounts, car payment, credit cards, and any child support you pay.
Calculating Debt to Income Ratio
You can get your debt to income ratio if you divide your total monthly debt payments by your monthly income. If your debt to income ratio is lower than 36%, then you can be considered to be in good financial condition. However, your personal situation, your unique expenses, and your number of dependants will determine how much debt you can reasonably pay each month.
What Ratio is Good?
If your debt to income ratio is:
- Less than 30 percent- you are in excellent financial condition.
- 30-36% – you will have no trouble with lenders, but should work to bring this number down to 30 or less
- 36-40% – you will most likely be able to get a loan, but you may have trouble meeting your monthly payments
- 40 percent or higher – you will need to evaluate your finances and work towards eliminating debts.
Credit Card Debt
Your debt to income ratio may be affected greatly by your credit card debt. The amount you owe on your credit cards has a direct effect on your credit score. If your debt exceeds your income, your credit score will drop. Many factors go into determining your credit score, all of which are indicators of your overall financial health. Lowering credit card debt is one of the best ways to improve your credit score and your debt to income ratio. According to a survey, an average American has over $8000 in credit card debt.
Even if you pay the minimum payments each month, it will still take a handsome amount out of your income. Even if your credit history is excellent, with very few or no late payments, if you have too much debt, you could be denied a loan.
How to Take Control of Your Credit Score
You can take control of your credit score by lowering your credit card debt or eliminating it all together. This will cause your credit score to rise and you will lower your debt to income ratio. If you plan to apply for a loan, purchase a new home, or want to buy a new car, you must make sure your level of debt does not exceed more than 36% of your income.
Also, in case you have credit cards with very low or zero balances, it would be better for you to close those accounts and transfer any outstanding balances to a credit card with a low interest rate. It is also advisable that if you have a number of dependants, try to get your debt to income ratio to come around 20% to ensure that you can pay your monthly debt comfortably.
