Debt-to-Income Ratio: Striking a Balance

Figure out your debt-to-income ratio.

Striking a balance between the debt you owe and the income you earn is vital. If you’re carrying too much debt, chances are your financial health is suffering because your income can’t sustain the monthly payments. The opposite occurs if the debt you’re carrying is low and your income can comfortably cover it.

How do you figure out if your debt is too high or low relative to your income? You need to figure out your debt to income ratio.

Before we go any further let’s test your skills on this subject.

KOFE Break!

Test your know-how before you start to see how much help you need. Can you skim this section or do you need to take some time on this topic?

What is a debt-to-income ratio?

A debt-to-income ratio is a financial formula that compares a person’s debt payments to their total monthly income. A high debt-to-income ratio signifies financial trouble. A low ratio signifies financial balance and stability.

The bottom line is, if you can’t strike a healthy balance between your debt and income, you’re inviting financial turmoil into your life. And the consequences vary, as you’ll discover further down the page.

How to calculate your debt-to-income ratio

This may sound a bit confusing, but it’s very simple. Just follow these directions:

1. Using your budget, add up your total monthly household income, including income from work, tips and commissions, any alimony or child support you receive, rental income, government benefits and so on. If your spouse works or receives income from other sources, include that too.
2. Next, use your budget again and total up your monthly debt payments. The calculations should be based on the minimum payments due for each debt, but if you pay more than the minimum, check your statement for the current minimum payment required. Don’t include payments for your mortgage, which should not be included in this ratio. This is your Total Monthly Debt.
3. Divide your Total Monthly Debt by your Total Monthly Income. The result will be a percentage. This is your debt-to-income ratio.

KOFE Break!

Do you have a good or bad DTI?

If your DTI is less than 20%, then you’re in good financial shape. If it’s higher, it means you’re carrying too much debt. This ratio is cut and dry. There’s no wiggle room.

Use our debt to income ratio calculator to calculate your DTI.

Lending institutions such as banks and credit card companies frown upon a high DTI. If you’re lucky enough to get approved for a loan or line of credit, you probably won’t qualify for the attractive terms they offer. You’ll be stuck paying much higher rates, which puts you further into debt.

Advantages of a low DTI

• Appeals to new creditors and lenders when you apply for a new loan or line of credit
• Indicates financial stability, so you are confident your finances are healthy
• Allows you to build savings because all of your money isn’t going to debt payments

Disadvantages of a high DTI

• There is little-to-no money left in your budget for savings
• Increases financial and personal distress in your life
• You won’t be able to qualify for loans and credit cards, or if you do qualify you’ll face much higher interest rates

How to lower your DTI

If your DTI is above 20 percent, it’s imperative that you do something about it now. You have two choices, (or you can do both):

1. Decrease your debt load. Pay off credit cards and other debt such as car loans. Be aggressive. Make sacrifices if it’s necessary – such as reducing spending in other areas of your budget so you can apply that money to your monthly payments.
2. Increase your income level. Take a side job, do freelance work or ask for more hours if you’re an hourly employee. Sell stuff in your home that you don’t use on eBay. Be creative.

Debt-to-income that includes housing costs

There’s another DTI – this one includes mortgage payments (or rent, if you don’t own). Housing costs are usually the biggest part of most budgets. The monthly costs can more than double your debt load when you add it in; this is the number that mortgage lenders use to decide if you qualify for a mortgage on a new home.

They will then take your regular DTI and add the payments for the home you want to buy. As long as your DTI (including housing costs) is less than 41 percent, then you’ll most likely qualify for the mortgage.

The first step is getting your regular DTI under 20 percent.