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What is the debt to income ratio?
Your debt to income ratio is your monthly debt payments divided by your gross monthly income. It is expressed as a percentage and used by lenders to determine how well you manage your debt and if you can afford to repay money you borrow.
This metric is used by lenders to determine how likely you are to repay an additional loan. If your ratio is too high, this indicates you have a lot of debt relative to your income and you may have trouble paying back a lender during periods of unforeseen financial hardship.
The debt to income ratio tells you how much of every dollar you earn is being used for debt.
For example, if your gross monthly income is $2,000 and your monthly debt payments total to $500, then your debt to income ratio is 25%. This means that for every dollar you earn, 25 cents is going towards paying off debts, leaving you with 75 cents for everything else.
How do you calculate debt to income ratio?
To calculate your debt to income ratio, you need to calculate:
- Your monthly debts
- Your gross monthly income
To calculate your monthly debts, you will want to add up all of your monthly debts. This includes:
- Credit card payments (use the minimum monthly payment required)
- Child support
- Student loans
- Car loans
- Personal loans
- Mortgage payments or rent
Monthly debts do not include:
- Utilities, like water, electricity or gas bills
- Insurance premiums, like health or car insurance
- Cell phone bills
Gross monthly income
Add up all of your monthly income. Income is any money you expect to receive regularly. This includes your paycheck as well as any alimony or child support payments you may receive.
Gross monthly income means that the income is before taxes. For most people, you can take your annual salary and divide it by 12 to get your gross monthly income.
More concretely, gross monthly income includes:
- Tips and bonuses
- Social security
- Child support
Divide your total monthly debts by your monthly gross income
To calculate your debt to income ratio, take your total monthly debts and divide that by your monthly gross income.
Convert this to a percentage by multiplying by 100 and you have your debt to income ratio.
Let’s look at an example to understand how to calculate your debt to income ratio.
You have a salary of $120,000 per year and receive a $5,000 bonus at the end of the year. Each month, you need to pay $100 in minimum credit card payments, $400 in student loans, and $1,500 in rent. What is your debt to income ratio?
Let’s first calculate your gross monthly income. Your gross annual income is $120,000 + $5,000, which is $125,000. We divide this by 12 to get your gross monthly income, which is $10,417.
Now let’s calculate your monthly debts. We can add up all of your debts, which is $100 + $400 + $1,500. This sums up to $2,000.
Your debt to income ratio is your monthly debts of $2,000 divided by your gross monthly income which is $10,417. This comes out to 0.19. If we multiple this by 100, we get 19% and that is your debt to income ratio.
What is a good debt to income ratio?
Generally, a debt to income ratio of 20% of lower is considered to be very good. At this level, you are managing your debt well and you likely have money left over after paying off your bills. From the lenders’ perspective, you could take on more debt and be able to pay it off.
A debt to income ratio of 36% to 49% is higher and you have room to improve. You might want to consider lowering your debt to income ratio and build more of a financial cushion to handle unexpected expenses or hits to your income.
A debt to income ratio of 43% is generally the highest debt to income ratio you can have to still get a Qualified Mortgage. A Qualified Mortgage is better because it excludes certain risky loan features and requires the lender to meet certain requirements.
A debt to income ratio higher than 50% is too high, and you should take action to reduce it. Your borrowing options may be limited.
Importance of the debt to income ratio
The debt to income ratio is a good ratio for you to keep track of. Why? If it is too high, you are more likely not to be able to pay your debts if you have any hits to your income. For example, you could get laid off or the bonus you were expecting falls short of expectations.
A lower debt to income ratio gives you a financial buffer in the case of financial hardship.
For lenders and creditors, the debt to income ratio is an important measure for risk. They want to know how likely a borrower is to default on a loan. The higher the debt to income ratio, the more likely the borrower will be unable to repay the loan.
Does your debt to income ratio affect your credit score?
No, your debt to income ratio will not affect your credit score. This metric is not used by credit reporting agencies’ in their calculation of your credit score.
A related metric, credit utilization, is used to calculate your credit score, and this metric is correlated with your debt to income ratio. Credit utilization is the ratio of your credit card balances to your credit card limits. How much of your the credit available to you do you use?
Generally, those who have high credit utilization are also more likely to have a high debt to income ratio.
How to improve your debt to income ratio?
There are many ways to deduce your debt to income ratio. You can either reduce your debt, increase your income, or do both.
Reduce your debts
- Create a budget: Reduce your credit card payments by tracking your spending and cutting unnecessary expenses.
- Create a plan to repay your debts: Creating a plan to repay your debts can help you reduce your overall level of debt. Two popular methods for doing this are the snowball and the avalanche/ladder method.
- Consider refinancing your debts to reduce your monthly payments: If you can refinance your debts at a lower interest rate, you reduce your monthly payments and your overall debt level.
- Avoid taking on more debt: Taking on more debt will increase your debt to income ratio. This is not advised for those who want to decrease their debt to cinema ratio.
Increase your income
- Improve your skills: Improving your skills in the workplace could help you land a promotion or a higher paying job.
- Take on side jobs: Taking on part-time work or side jobs also increase your income and reduce your debt to income ratio.