Do you have too much credit card debt? How can you get great mortgage loan rates? Can you afford a house? To answer these questions, you can evaluate your debt load by figuring out your debt to income ratio.
When I hunted for a mortgage several years ago, I was required to assess my debt to income ratio, which represents how much I owe on my credit cards and other loans versus my monthly income.
Having too much debt can make it more difficult to get financing, so it’s worth it to take the time to study the numbers every so often. It’s something I try to do once in a while to make sure I’m not going overboard with what I owe.
Thankfully, sites like Bankrate.com are around to help us with determining the factors we need to help us with these calculations. So here are the steps I’ve taken to get a handle on my debt to income ratio as a benchmark for my debt load:
Debt management is a balancing act, just ask shutterclick.
How To Calculate Your Debt To Income Ratio
1. List your debts.
First, list the various debts held by members of your household:
- Current monthly mortgage or rent paid
- Any home equity loans you might have
- Any car payments
- Monthly credit card payments
- Student loan payments
- Other types of loans (like ones from the furniture store, boat loans, etc.)
- Miscellaneous debts not listed above (like the $500 I borrowed from a relative during a medical crisis, which I divide by 12 to get the monthly payment amounts)
- Other obligations like child support, alimony, etc (if applicable)
Then note the total amount of debt each month. It’s unnecessary to include your non-debt expenses like utilities or food in the debt to income ratio, though knowing the amount of your total expenses will hopefully help you stop overspending.
2. Note your income.
For income, list down the following:
- Monthly take home pay (your paycheck minus the various deductions)
- Your partner’s monthly take home pay
- Miscellaneous monthly income (such as from eBay or other sales, if it’s regular income)
- Monthly investment income (if you have it available)
Note the total monthly income amount.
3. Make the calculation.
Your total monthly debt divided by your total monthly income gives you the debt to income ratio. Or in other words:
Total Monthly Debt/Total Monthly Income = Debt to Income Ratio.
4. Check out your score.
Here’s the rule of thumb: a number of less than 30% is excellent; 30% to 36% is good, while 36% to 40% means you’ll have a harder time securing loans and you may run into trouble making payments.
So How Much Debt Do You Have? The Ratio’s Red Flag
And if the ratio is above 40%, we’d be in red flag territory. After all the coverage of the subprime mortgage problem, I’ve learned that it’s never a good idea to have more debt than we can handle; my goal has always been to make sure I work and communicate with the rest of my family to reduce our total debt as quickly as possible.
Our strategy has been to reduce our debt load and whatever we can’t eliminate, we try to work out a better interest rate for those loans. There are many ways to make debt reduction work: we’ve tried lowering our interest rates by performing balance transfers. Some other strategies include trying to get rid of our debt by eliminating our high interest debts first. We then recalculate the ratio to see if we’ve reduced it enough. For those high interest debts that are too massive to reduce at a fast pace, we’ve tried to pay off the smaller loans first; it’s the best we can do even if we end up paying more interest in the long run. Here are some additional debt elimination tips we follow.
How much debt should we carry? Image by shutterclick.
Improving The Debt To Income Ratio for Better Borrowing
In addition, I’ve been trying out ways to increase my income — I’ve looked into taking on a part-time job, I’ve checked out freelancing and odd jobs, and have been selling my craft goodies online. Right off the bat, I can think of ways to cut my non-debt expenses like groceries, clothing, entertainment, and my big money sink: gifts!
Note, though, that the best time to calculate your debt to income ratio is before you buy a house. It’s used to help you get better home loan rates and qualify for a mortgage loan or some other loan. So if you want to move to another neighborhood and take on a bigger mortgage, you should study your numbers to see if adding more debt would affect the ratio negatively. This means you shouldn’t take on a $1600 a month mortgage if the jump would make your other debts harder to pay.
It’s been pretty easy for me to work out these calculations for my family’s finances. I’ve been able to pull the necessary numbers to compute my household’s ratio from financial tools such as Quicken, Mint and YNAB (You Need A Budget) personal budget software, which I then plug into a debt to income ratio calculator.
Staying in good financial shape doesn’t take a lot of arcane calculations. By keeping an eye on your debt to income ratio, you’ll find it more of a breeze to apply for your next big loan.
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