The amount of money you owe is only relevant when measured against your income. If you’re fabulously wealthy, $15,000 in credit card debt is but a trifle. If you’re the average American, $15,000 in credit card debt gives you nightmares.
Your debt-to-income ratio represents the percentage of your income you use to pay your debts. Most banks and financial professionals suggest that you should maintain a debt-to-income ratio of 36 percent or less of your gross income. If you want to get an idea of what you should aim for, simply take your monthly gross income and multiply it by 36 percent.
$3,500 x .36 = $1,260
In this example, your debt payments should not exceed $1,260 per month. This gives you a quick reference as to how much of your income is considered a comfortable debt load.
What Does Your Ratio Mean?
For lenders, your debt-to-income ratio indicates your ability to repay debt. A low ratio indicates that you have a higher likelihood of repaying your debt. The higher your ratio, the more of a credit risk you become. With a debt-to-income ratio in excess of 36%, affordable credit may be hard to come by, though many lenders may still have loan products that fit your personal situation.
Determine Your Debt-to-Income Ratio
Fill in the blanks below to calculate your debt-to-income ratio. You will need to know all your sources of income, as well as all of your debts, including your mortgage or rent, car payment and other loan payments, such as school loans, home equity loans, and personal loans. Don’t include your household expenses, like utilities or grocery bills.
Your debt-to-income ratio
36% or less: This is a healthy debt load to carry for most people.
37%-42%: Not bad, but start paring debt now before you get in real trouble.
43%-49%: Financial difficulties are probably imminent unless you take immediate action.
50% or more: Get professional help to aggressively reduce debt.
Source: Gerri Detweiler, author of The Ultimate Credit Handbook
What Do You Do If Your Ratio Is Too High?
You have two basic options to improve your debt-to-income ratio:
- Increase your income
- Lower your expenses
Increasing your income much more difficult, but possible. Consider the following options:
- Assess your current salary and job situation. Is there potential for you to transfer your skills into a higher paying job?
- Get a part-time job. You may only need to do this for a short time to decrease your debt and improve your debt-to-income ratio.
- Review your investments and savings accounts. Can you move some of your money to higher yielding accounts?
Decreasing your expenses may not be easy either, but it’s probably easier than increasing your income. Track your spending to see what discretionary expenses you can eliminate and put that cash toward paying down debt. Implement a budget to help you make better spending and purchase decisions. Calculate your debt-income-ratio is a good first step to getting a handle on your finances, but don’t forget to take the necessary actions to get out of debt. Following the guidelines above can put you on the path to a good credit rating.
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