Your debt-to-income ratio measures the amount of your income being spent on debt each month. Most mortgage lenders consider the ratio to calculate the monthly mortgage payment you qualify for. It can be helpful to calculate your own debt-to-income ratio so you can see whether you've overborrowed relative to your income.
The lower your debt-to-income ratio, the better because it means you don't spend much of your income paying debts. On the other hand, a high debt-to-income ratio means more of your income is spent on debt, leaving you with less money to spend on other bills or save and invest.
Calculating your debt-to-income ratio is fairly simple. You can start by adding up your monthly debt payments, including credit cards and loans. Then, divide that number by your gross monthly income. Multiply the result by 100 to get a percentage. For example, if you spend $1,200 each month on debt and have a monthly income of $4,000, your debt to income ratio would be 30%.
Use your billing statements and checking account transactions to determine what you spend on debt payments each month.
High Debt-to-Income Ratio
If your debt-to-income ratio is more than 50%, you definitely have too much debt. That means you're spending at least half your monthly income on debt. Between 36% and 49% isn't terrible, but those are still some risky numbers. Ideally, your debt-to-income ratio should be less than 36%. That means you have a manageable debt load and money left over after making your monthly debt payments.
Impact of a High Debt-to-Income Ratio
A high debt-to-income ratio can have a negative impact on your finances in multiple areas. First, you may struggle to pay bills because so much of your monthly income is going toward debt payments.
A high debt-to-income ratio will make it tough to get approved for loans, especially a mortgage or auto loan. Lenders want to be sure you can afford to make your monthly loan payments. High debt payments are often a sign that a borrower would miss payments or default on the loan.
While your credit score isn't directly impacted by a high debt-to-income ratio, some of the factors that contribute to a high debt-to-income ratio could also hurt your credit score. More specifically, high credit card and loan balances, which may play a role in your high debt-to-income ratio, can hurt your credit score.
How to Reduce Your Debt-to-Income Ratio
There are times when having a high debt-to-income ratio makes sense. For example, it's not terrible to have a high ratio if you're aggressively paying off your debt. On the other hand, if your ratio is high and you're only making minimum payments, that's a problem.
Generally, there are two ways to lower your debt-to-income ratio. First, you can increase your income. That could mean working some overtime, asking for a salary increase, taking on a part-time job, starting a business, or generating money from a hobby. The more you can increase your monthly income (without simultaneously raising your debt payments) the lower your debt-to-income ratio will be.
The second way to lower your ratio is to pay off your debt. While you're in debt repayment mode, you'll have less discretionary income at your disposal because you'll be spending more of your monthly income on debt payments.
If you need help lowering your debt-to-income ratio, a nonprofit credit counselor can help you come up with a personalized plan.