If you’ve ever applied for a mortgage or loan, you may have heard the term debt to income ratio. But you may not have learned what it really means, let alone how to calculate it or how it has to do with the rest of your finances.
Debt to income ratio might sound like an overly complicated term. In reality, it’s a simple concept that could help you understand and even improve your financial situation. Here’s what you need to know about your debt to income ratio.
What Is Debt to Income Ratio?
Debt to income ratio is the percentage of your monthly income that goes to paying debts. Creditors calculate your debt to income ratio to find out how much additional debt you can take on.
A lower debt to income ratio could make it more likely to get approved for a loan or mortgage. If a creditor sees that your debt to income ratio is too high, on the other hand, they may view you as a risky borrower.
Calculating your debt to income ratio is easy. All you have to do is add up all of the monthly debt payments you make to credit cards, personal loans, mortgages, and any other debt, and then divide that number by your gross monthly income. After that, you multiple the number by 100 to get the percentage of debt to income.
For example, if you put a total of $1,500 towards your debt every month and your monthly income before taxes is $6,000, your debt to income ratio would be 25%. In mathematical terms, here’s how you calculate debt to income ratio:
[Total Debt Payments]÷[Gross Income])x100=[Debt to Income Ratio]
How to Tell If Your Debt to Income Ratio Is Too High
If your debt to income ratio is below 36%, most creditors will consider you for a new loan or mortgage. If it’s between 37% and 49%, some creditors might view you as a credit risk but may still lend to you. But if your debt to income ratio is above 50%, most creditors could reject your application for a new line of credit.
Keeping your debt to income ratio low is a good idea—especially if you plan to take out a large loan or mortgage. But it’s not the only factor that helps creditors decide if they should lend to you. Your credit profile is also a big part of their decision making process.
Many people think that your debt to income ratio and credit profile are the same thing—but that’s not true. That’s why it’s important to know the difference between credit profile and debt to income.
Credit Profile vs. Debt to Income Ratio
Even though a low debt to income ratio could help you qualify for a loan, your credit profile is also an important consideration for many creditors when they decide whether to lend to you. While your debt to income ratio might help a creditor decide how much to lend to you, your credit profile helps them choose the length of your loan and your annual percentage rate (APR).
Before they decide on your loan terms, almost every creditor looks at your credit profile,. Factors like your payment history, credit utilization, and credit history contribute to your credit score and help creditors determine your likelihood to pay back the loan.
At the end of the day, both your credit profile and your debt to income ratio contribute to your credit worthiness. So if you have an excellent credit profile and low debt to income ratio, you could be a good candidate for a loan.
What No One Tells You About Your Debt to Income Ratio
Your debt to income ratio isn’t just a number that creditors use to decide how much they should lend you—it could also indicate your overall financial wellbeing. If you have a high debt to income ratio, chances are that you might not be able to save as much as you would like each month.
Similarly, you may not feel prepared for an unexpected financial hardship—like a job loss, or illness. To make things worse, you may not have an emergency fund to cover you in case you get hit with an expense you didn’t plan for.
Even if your debt to income ratio is hovering around 35 or 40%, your finances might be in danger without you realizing it. A high debt to income ratio could mean that you have high credit utilization. And since credit utilization makes up 30% of your credit score, high debt to income might be an early sign of declining credit.
The bottom line is that your debt to income ratio could clue you into the fact that you’re spending too much on debt, and not enough on your future. Reducing your debt to income ratio is not just a good idea if you’re applying for a loan or mortgage—it could also improve your overall financial wellbeing. While there are many ways to reduce your debt to income ratio, some methods are better than others.
How to Reduce Your Debt to Income Ratio
If you want to reduce your debt to income ratio, making minimum payments could be a bad choice. Paying the minimum payments could take you years to pay off debt and cost you thousands in interest alone. And if you want to accomplish big financial goals, making minimum payments could delay your plans indefinitely.
Consolidating your debt with a personal loan could be a better choice than making minimum payments, but you might have trouble qualifying if your debt to income ratio is already high. Since debt consolidation loans are just another form of debt, you still have to pay interest on top of your principle debt. To make things worse, your new rate may not be much lower than it is on your current debts because it’s hard to get a loan with a favorable rate and terms if you have high credit utilization.
Debt negotiation could be the right choice for many Americans who are struggling with high debt to income ratios. Companies that offer debt negotiation, like Freedom Debt Relief, could help you get out of debt faster than minimum payments and for less than what you currently owe. In fact, enrolling in the Freedom Debt Relief program could help you reduce your debt to income ratio and get rid of debt in as little as 24-48 months.* To find out if our program is right for you, visit our website or request a free debt consultation now.