An estimated 80% of Americans have debt that they don’t want. And while debt can feel like a ball and chain, it’s your debt ratio that really matters.
It affects things like how much you qualify for on a mortgage or whether you can get a good rate when you finance a car.
So how do you find out your debt to income ration, why does that matter, and what can you do about it? We explain all here.
What is a Debt to Income Ratio?
Your debt to income ratio is how much of your income you spend every month on debt payments. What’s interesting is your housing expenses like rent or mortgage principal (plus interest, property taxes, and insurance) are factored into your debt ratio.
We also look at your gross income (before taxes) to figure out this number.
Here’s how you find it. Write down how much you made last month in money. Then list out all of your debt bills. It’ll probably look something like this:
Paycheck 1 (before taxes): $2300
Paycheck 2 (before taxes): $2300
Total Income: $4600
Discover: $50
Capital One: $125
Master Card: $33
Student Loan: $325
Car Payment: $180
Rent: $900
Total Debt Expenses: $1613
Now we divide the total debt expenses ($1613) by the total income ($4600) to get 0.35. When we express that as a percentage, it’s 35%. So in this case, the total debt ratio is 35%.
Now I Know My Debt Ratio, Why Does it Matter?
A debt ratio is an important number for lenders to know because it helps them decide if you can safely take on more debt.
If you’re spending over half of your income to pay off debt (or very close to it) at some point you’ll likely default on some of those payments. Other expenses can crop up, you may lose an income stream, or something might just get lost.
In other words, you may not be able to repay back the debt if you’re spending too much of your income on debt payments.
So what’s a high debt to income ratio? Standards vary from lender to lender, but most of them don’t like to lend out money if it’s higher than 36%. So our friend in the example above would have a hard time getting new credit.
If a debt ratio of 36% is high, then what is a good debt ratio? That will depend on a handful of factors, but generally, you want your debt ratio to be as low as feasibly possible.
If you’re debt-free, or if all your debt is in valuable assets like income-generating real estate, that’s a good place to be.
Your Debt to Credit Ratio is Important Too
But while we’re on the topic, another debt ratio you should pay attention to is your debt to credit ratio. This is how much of your available credit you’re using up.
To find your available credit, look at all the lines of credit you have access too and their maximum balance amount. So if you have two lines of credit at $2000 each, and a third at $5400 and one more at $1000, your total credit limit is $10,400.
Ideally, lenders want to see a ratio of less than 30%. This is the total balance you’re carrying on each card. While creditors look at the total debt to credit ratio, the ratio per card matters too.
So if you’re total credit limit is $9000 over three cards with a $3000 limit on each, but one is maxed out and the other two don’t carry anything, creditors will look at that more harshly than if each card only carried $1000.
That’s because one card is completely maxed out, not an ideal situation.
How Can I Fix My Debt Ratio?
The absolute best way to fix your debt ratio is to pay down your debt as quickly as possible. There are a couple of steps to getting this done.
First is to stop getting more debt. You need to sit down with a budget and figure out where each dollar needs to go, and stick to those numbers.
A really common way people get into debt is by using their credit cards to cover common household expenses like groceries or birthday gifts. It’s time to stop that and get your spending under control.
Once you have your budget figured out, look to see where you can cut back. This extra wiggle room in your budget means that you can put more money towards your debt.
The most common areas people can cut back are on extraneous shopping, eating out, and yes, coffee shop coffees. But also look at your subscriptions. Are you getting several subscription boxes like loot crate or other goodies? Do you really need both Netflix and Hulu an Amazon Prime?
Once you’ve freed up some wiggle room, make more debt payments. Even making several payments a month will lower the overall monthly balance, and thus the interest you’ll owe on it.
Paying off debt is hard because it means you have to control your spending and cut back on things you love. But getting debt free is rewarding. It means you can get that mortgage you want at a good rate, or qualify for a loan that you really need.
It also helps to boost your credit score which affects the rates you’ll pay on any future debt. It’s hard to repair credit on your own, but not impossible. If you’re struggling, consider seeking professional help.
Your Debt Ratio Affects the Quality of Future Debt
Your debt ratio matters a lot, especially if you’re looking to take on a big new debt like a mortgage or financing a new car. Your debt ratio and credit score affect how much you qualify for, and what kind of a rate you’ll be paying for it. That’s why it’s a good idea to pay it down so you can get the best deal possible.
At Plunged in Debt, we prove that appearances don’t reveal financial security. Want to learn how to get out of debt? Explore the site to find out.
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