Credit and Debt Management
May is known as a transitional month where we experience a favorable change in the weather, spring cleaning and planting, graduations and preparations for ending the school year. Financially, many people take a long look on how they are doing as we approach the half-way point of the year.
In May, I have concentrated on providing you information about debt and how to manage it. Our first two posts in May were about Debt Reduction and Debt Consolidation. This week, I want you to learn how others view the relationship between your debt and income. You will learn how to analyze and manage your debt by understanding your Debt to Income Ratio.
What is a Debt to Income (DTI) Ratio?
It is a percentage of your income in comparison to the debt that you are responsible for. Usually described in monthly terms, it’s the amount you spend paying your debts every month divided by your monthly income.
What is it used for?
It is used as a tool to gauge the percentage you are spending on debt. Lenders, especially auto and home mortgage lenders, use it to determine your qualification for a loan. To be specific, the DTI is used to determine how much you can afford to borrow. The theory is that the higher the percentage, the higher the lender’s risk that you might not make your payments on time (or at all!). A lower DTI would suggest that you have more money left over after paying off your monthly debt to put away toward spending and savings. On the other hand, a high DTI ratio would indicate that you have very little money to spend or save.
What is a high DTI ratio?
In general, a ratio of 50% and higher is considered to be very high. At this level, you should not be taking on any more debt. A ratio between 37% – 49% is still high but not outrageous. Warning – life in this range can still be challenging for most people. A ratio under 36% or lower is where everyone needs to strive to be. At this level, lenders are typically willing to lend you money at their lowest rates.
Figuring out your DTI ratio is pretty simple, just list and total all your monthly expenses (debt) as well as your income and then divide the debt sum by the income sum. Here is a link to a worksheet provide by About.com to help you calculate your DTI http://credit.about.com/library/worksheets/DebtToIncomeRatioWS.pdf.
So how can you reduce your DTI ratio?
There are only three ways to reduce your DTI. You can either increase your income, reduce your debt or a combination of the two. If you keep your debt from increasing at the same time that you earn more income, your ratio will fall. Of course there are several ways to increase income such as: earn more money on the job by getting a promotion or working overtime, finding additional employment or a new job that pays more, or starting a business of your own to earn extra cash.
Choose the way that works best for you, and you’ll find your debt load shrinking, your savings account growing and your debt-to-income ratio falling. Like spring cleaning, cleaning up our personal financial portfolio needs to be done. However, keeping it healthy and strong is a habit that needs to be learned.
Now that you know how to decrease the amount of debt you’re living with, you need to learn how to stay out of debt in the future. Next week I will provide some tips on how to avoid being in debt.