Understand Your Debt-to-Income Ratio or Creditworthiness

FICO Scores

One measurement in your FICO score compares your debt payments to your income. This measurement is important because it gives lenders an idea of how likely you are to make your payments. The higher this ratio, the more difficulty you will have in making payments. Also, if the ratio is too high, you will have a hard time getting other forms of financing.

Your Debt-to-Income Ratio is the percentage of your monthly pre-tax income that is used to pay off debts. Lenders look at two ratios:

• The percentage of gross (pre-tax) monthly earnings that are spent on house payments or rent
  
  
• Other debts are factored in along with the house payments

Debt-to-Income Ratio is Calculated By:

Monthly Debt Expenses ÷ Monthly Gross Income = Debt-to-Income Ratio

Here’s an example of this calculation:

A Good Ratio

Most banks and financial professionals agree that you should keep your debt-to-income ratio at less than 36 percent of your gross income.

If your debt-to-income ratio exceeds 36%, you may have trouble finding affordable credit. However, many lenders also evaluate other circumstances and may still have a loan to offer that fits within your own personal situation.

• 36% or Less

For most people this is an acceptable debt load.

• 37% - 42%

Not too bad, but you should find a way to pay down your debt now before you get in real trouble.

• 43% - 49%

You should start making plans to get out of debt. You are at a point where an emergency or job loss could leave you in financial ruin.

• 50% or more

This means you are in a debt crisis and need to find help as soon as possible.

Calculate Your Debt-to-Income Ratio

Now, calculate your own debt-to-income ratio. To do this:

• Determine your monthly debts.

Look at your recent credit card statements to see what you've been paying on average each month. You will also need to know what you pay for all of your other long-term recurring debt (mortgage / rent payment, car payment, other loan payments, such as school loans, home equity loans, personal loans). Do not add in your household expenses, like utilities or grocery bills.

• Determine your total monthly income.

If you do not have a fixed salary, you will need several of your recent pay stubs to determine your average monthly gross income. Remember, gross income is your wages before any taxes or other deductions. Also, if you are paid every other week, take this pay and multiple by 2.

• Divide your monthly debt expenses by your monthly gross income to arrive at your debt-to-income ratio.

What should you do if your ratio is too high? To improve your debt-to-income ratio, you only have two options:

• Increase your income

Increasing your income is usually more difficult than lowering your expenses, but it can be done. Some ideas to consider are:

• Take on a second or part-time job. We know this isn’t always the best solution, but think about it. Perhaps there is something you can do from home. This may only need to be a temporary solution until you lower your debt load.

• Take a look at your current job and assess the salary you are receiving for the work you perform. Does your company pay you market wages for the job you currently have? Can you transfer your job skills into a higher paying job?

• Review your investments and savings. Assess the rate of return you are getting. Can you move some of your money to accounts with higher yields?

• Lower your expenses

Lowering your expenses may not be so easy either, but many times it is easier than increasing your income. It is a good idea to get on a personal budget. This will help you see where you are now and help you determine how to get where you need be in the future.

Things You Can Do To Lower Your Expenses

Set up an automatic bill paying system.

This will ensure that you pay your bills on time and minimize charges for late payments, which cost you money. For bills that do not have an automatic payment option, pay them when you get paid. This way you will minimize the risk of spending the money you should have used to pay your bills.

Use a debit card and not your credit card

Using a debit card ensures that you only spend money that you actually have. Since the money comes directly out of your checking account, you will tend to be more responsible with the purchases than you would be with a credit card.

Do it yourself

Wash your own car, do your own gardening or lawn mowing. Clean your own carpets or groom your dog yourself. There are many things you can do that will save money.

Shop around before you buy

Never impulse buy. When you need to make a purchase, it is important that you get the best deal for your money. There is a lot of competition in the market and companies are doing everything they can to attract customers and increase their sales. Find these offers and take advantage of the savings. Bargains can be found all over – from the grocery story to the car dealership. You will be truly amazed at how much savings you’ll get if you shop around first.

Start a savings account

If you don’t already have one, start one right away. It is needed for emergencies and unexpected expenses such as car repairs or an emergency room visit. You will reap the reward of not needing to borrow money or use your credit card. And over time, you will earn dividends that you wouldn’t have otherwise.

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