Debt Ratio

One of the quickest-and most revealing--ways to get a handle on your current financial picture is to calculate your debt-to-income ratio. Lenders look at your debt-to-income ratio when they consider if you are creditworthy. This article will help you answer the following questions:

What is a debt-to-income ratio?
How do I calculate my debt-to-income ratio?
What is an acceptable debt-to-income ratio?
Why is monitoring my debt-to-income ratio important?

What is a debt-to-income ratio?

A widely used measure of financial stability, your debt-to-income ratio is calculated by dividing monthly minimum debt payments (excluding mortgage or rent payments) by monthly gross income. For example, someone with a gross monthly income of $2,000 who is making minimum payments of $400 on loans and credit cards has a debt-to-income ratio of 20 percent ($400 / $2000 = .20).

Other authorities may offer slightly different definitions of debt-to-income ratio. While variations will result in different percentage outcomes, the overall concept is the same: a debt-to-income ratio compares debt load to income.

How do I calculate my debt-to-income ratio?

The first step in calculating your debt-to-income ratio is figuring your monthly gross income, which is your income before taxes or other deductions. (This is usually the easy part because most people can remember what they earn much more quickly than what they spend!)

Here are some tips to help you remember all your income:

If you're paid every other week, your monthly gross income is your gross income from one paycheck times 2.17.
Regular income from alimony and child support can be counted as income.
Include conservative averages of bonuses, commissions and tips.
Don't forget dividends and interest earnings.
Include miscellaneous income such as government benefits and/or assistance.
Next, list the current minimum payment on all your credit purchases and loans (except mortgage). Be sure to include car payments, installment loan payments on furniture and appliances, bank/credit union loans, student loan payments, other loans/credit lines, all minimum credit card payments, and payments for past medical care.

Your Debt-to-Income Ratio is:
Monthly Gross Income / Total Debt Payments = Debt-to Income Ratio

What is an acceptable debt-to-income ratio?

Generally, the lower your debt-to-income ratio, the better is your financial condition. A recommended debt-to-income ratio is under 15 percent. A ratio of 20 percent or higher signals a need to control credit and to begin a plan for regaining financial stability. Ideally, you will carry little or no debt so your income can be saved, invested, or spent as desired, rather than used on interest.

Why is monitoring my debt-to-income ratio important?

Most importantly, you can avoid "creeping indebtedness" by staying aware of your debt-to-income ratio. Knowing your debt-to-income ratio will help you make sound decisions about making purchases on credit or taking out loans. Keeping your debt-to-income ratio under 20 percent will help you avoid major credit problems.

Because it is such a powerful indicator, lenders look at your debt-to-income ratio when they consider extending credit. Letting your debt-to-income ratio rise will jeopardize your chance of making major purchases, such as a car or a home, when you desire. Also, if your ratio is high, you will find it difficult to get additional credit in case of emergencies. As a bonus, if you keep your debt-to-income ratio low, you will more likely qualify for the lowest interest rates and best terms when you apply for credit.