Keeping your debt at a manageable level is one of the foundations of good financial health. But how can you tell when your debt is starting to get out of control? Fortunately, there’s a way to estimate if you have too much debt without waiting until you realize you can’t afford your monthly payments or your credit score starts slipping.
Your debt-to-income (DTI) ratio compares your monthly debt payments to your monthly gross income. When you apply for things like a mortgage, auto or other type of loan, banks and other lenders use the ratio to help determine how much of your income is going toward your current debt obligations—and how much more you can afford to take on.
Begin by adding up what you owe every month on your debts. Include payments for:
Credit cards—use the minimum payment, even if you actually pay more
Loans of any type, including car, student, personal and investment property
Housing—either rent or mortgage payments plus interest, property taxes and insurance (PITI) and any homeowner association fees
Obligations such as alimony and child support
Next, determine your monthly gross income—that is, income before taxes and other deductions. Divide your monthly debt payments by your monthly gross income to get your ratio. Then multiply by 100 to express the ratio as a percentage.
Let’s say your debt payments add up to $2,000 each month and your gross income is $5,000 a month. Your debt-to-income ratio is $2,000 divided by $5,000, which works out to 0.4 or 40 percent. Put another way, 40 cents of every dollar you earn is used to pay off debt.
The lower your ratio, the better. The preferred maximum DTI varies by product and from lender to lender. For example, the cutoff to get approved for a mortgage is often around 36 percent, though some lenders will go up to 43 percent. Generally, a ratio of 50 percent or higher is considered an indicator of financial difficulties.
No, not directly. The ratio itself is not used to calculate your credit score. But factors that contribute to your ratio can also affect your credit. High credit card balances, for example, could hurt both your debt-to-income ratio and your credit score. Likewise, low balances could help both.
Both use debt levels to help lenders assess risk. However, as the names suggest, they compare debt to different factors. The debt-to-limit ratio, also called credit utilization ratio, measures how much of your total available credit you’re using. Lenders generally want credit card balances to be less than 30 percent of credit limits. The debt-to-limit ratio is the second biggest factor, behind payment history, in calculating credit scores.
If your debt-to-income ratio is higher than 36 percent, you may want to take steps to reduce it. To do so, you could:
Make a plan for paying off your credit cards.
Increase the amount you pay monthly toward your debts. Extra payments can help lower your overall debt more quickly.
Ask creditors to reduce your interest rate, which would lead to savings that you could use to pay down debt.
Avoid taking on more debt.
Look for ways to increase your income.
It also helps to recalculate your debt-to-income ratio monthly to see if you’re making progress. Watching it decrease can help you stay motivated to keep your debt manageable.