Figuring out where your personal finances stand is an important step in managing your debt. Your debt-to-income ratio will show you if you're in over your head or on track to be financially fit.
If you're good about keeping track of your finances, you probably have an estimate of your credit score, keep a budget and monitor your spending. But you may be missing an important component: your debt-to-income ratio.
It's important to know your debt-to-income ratio because creditors will use it when you're applying for credit, plus it will help you set your debt management goals.
Calculating Your Debt-to-Income Ratio
To begin, add up all your monthly debts, then all your monthly income. Don't forget child support and alimony should be factored into income. You then simply divide your debt by your income to get your ratio.
Here's an example:
- Mortgage $1,200
- Auto loan $222
- Student loan $150
- Miscellaneous debt $350
Total monthly debt = $1922
- Salary $5,000
- Miscellaneous income $470
Total monthly income = $5470
This debt-to-income ratio is 0.35 or 35%
Knowing Your Ratio is Important
Plenty of creditors will look at your debt-to-income ratio when making a decision about giving you a loan or credit. For example, this ratio will impact applications for:
- Auto loans
- Credit cards
- Some jobs
Because creditors, and even some employers, will be looking at this ratio, you want to have it as low as possible. If you're not sure what you should be aiming for, here's a good guideline.
36% or less indicates you're in good financial standing. You have debt, but you're handling it. You're probably even saving money every month, which makes you a safe bet for creditors.
37% to 42% is still healthy, you just may not have as much of a nest egg. You're paying your bills every month, and your debt may be slowly receding, but saving money is more difficult for you.
43% to 49% indicates a high debt load. 43% is typically considered the cutoff for getting a qualified mortgage. If your ratio is higher than 43%, you are most likely have trouble making monthly payments and may be headed for trouble.
Over 49% indicates severe financial troubles. You should seek professional financial advice for a strategy to reduce your ratio.
Reducing Your Debt-to-Income Ratio
If you did the calculations and aren't happy with your ratio, you're probably wondering how you can reduce yours. While there is no cookie-cutter solution, you can try the following.
Create a strict budget and monitor where your money is going every month. The digitized world has made it easy to view your accounts anywhere, anytime. Balance Financial is a wonderful resource that provides plenty of tips and tricks.
Consolidate multiple credit cards and other debts into a single personal loan. This will give you one easy payment with an estimated payoff date.
Refinance auto loans or mortgage with high rates. You can reduce your monthly expenses by refinancing for lower rates, as long as you're not close to your payoff date.
Please contact Community First Credit Union to discuss your financial concerns and learn how we can help.