You could be living an ignorant person’s life without having a prior idea on how to manage debts. Is it going out of proportion to your income?
Maintaining the debt at a manageable level is one of the factors to consider to maintain a healthy financial record. But how can you know if your debt is beginning to get out of control?
Well, there’s a way to calculate if you are carrying too much debt without having enough monthly income to repay or if the credit scores will start dropping.
What is a debt-to-income ratio?
The money, that you spend on your debt payments and other fixed expenses, is divided by the monthly income to obtain your debt-to-income ratio. Your debt payments will include the monthly expenditure for things like phone bills, internet bills, rent, etc. Added to that is the money you spend on services like groceries and transportation. Then the money spent on repaying the debt; it could be your auto loan, personal loan, student loan or average credit card bill.
DTI = Total monthly debt payments / Gross monthly income x 100
Types of debt-to-income ratios
Front-end and back-end ratios are the two types to ascertain how much is the debtor capable to borrow. Each ratio performs the function of comparing your current debt amounts to your gross monthly income.
The front end debt ratio is also known as the mortgage-to-income ratio. It is calculated by dividing your monthly mortgage payments by your monthly gross income. Usually, a monthly mortgage includes the principal, interest, taxes, and insurance amounts.
So, what is a good percentage of debt to income ratio?
The standard limit set by conventional lenders is 28%.
If you have a house, then the front-end ratio can be computed by calculating all the household expenses such as your mortgage payments and insurance which is divided by your gross monthly income.
If a consumer has a gross monthly income of $5,000, who owes $2,500 in monthly mortgage payments, would have a front-end DTI ratio of about 50%.
The back-end ratio determines what portion of a person’s monthly income is spent in paying debts. It is calculated by dividing the total monthly expenses (including all debts like mortgage, unsecured debts, etc.) by your monthly gross income.
Lenders utilize this ratio jointly with the front-end ratio to accept your mortgage loan request.
Back-end Ratio = Total Monthly Debt Expenditure/Gross Monthly Income x 100
If a person has a monthly income of $4,000, and has total monthly debt payments of about $1,500, then his/her back-end ratio is 37.5%.
Generally, lenders approve a back-end ratio that does not exceed the standard limit of 36%.
Things to know about a good debt-to-income ratio
a. You can calculate the ratios faster with an online calculator
You can easily get the DTI results by using a suitable DTI calculator online. Lenders are interested to look at your debt-to-income ratio and credit history to determine whether or not to lend you money.
In an online calculator, simply enter your estimated DTI ratio, your current income and payments; by clicking the option “Calculate DTI” you will be able to get the results faster.
b. You need to maintain the ratio below a certain percentage
Financial experts advise on keeping the debt-to-income ratio (back-end ratio) below 43% which includes your mortgage related payments. This can help maintain your debts at a manageable level, where you can easily pay them off in the near future.
Most lenders will not accept your mortgage extension request if your monthly payment will lift your debt-to-income ratio above 43%.
c. You should not utilize much of your gross income
Experts advise us to play it safe by keeping the gross monthly income not more than 33% toward the household expenses. This includes a mortgage and other expenses needed to maintain the house.
d. Your debt-to-income ratio does not influence your credit score
According to the experts, the debt-to-income ratio is not the factor to impact your credit score.Instead, it relies on a different variable called credit utilization, which calculates the amount of debt you have to the amount you are using.
We will be discussing about that now.
What is meant by debt-to-credit ratio?
Basically, the debt-to-credit ratio is the amount of debt you currently have which is divided by the amount of credit that’s available to you.
Credit Utilization Ratio = Outstanding balance/Available Credit Limit x 100
Things to know about a good debt-to-credit ratio
a. You can use an online calculator to find your ratio
One of the best ways to keep a track of your debt-to-credit-ratio is to focus on your finances, begin with a spreadsheet. In it, you can add a line for each account and write the total balance and the total credit limit.
Add the total balance for each account as well as the total credit limit for each account. Now, divide the total debt by your total available credit to obtain the ratio. Use an online calculator to compute the ratio. Simply type your balances and limits, and get the results.
b. Your credit score increases which improves the ratio
The credit utilization ratio has a vital role to play in your credit score calculations. It shouldn’t amuse you that improving your debt-to-credit ratio can improve your credit score too.
In fact, you can take help of debt-to-credit ratio calculation to improve your score in just a matter of few weeks. The reason being that those who provide credit send your updated balances to the credit bureaus in each statement period.
c. You can have a good ratio and still be in debt
It isn’t necessary to be debt free to have a satisfactory utilization rate or good credit score.
You must be wondering what is a good percentage of debt to credit ratio?
A good rule of thumb is to keep your total debt below 30% of your available credit.
Since the credit score gets updated on a regular basis, so the impact of carrying a high total balance can be resolved by clearing down that balance.
d. You need to have a good ratio to get the best rate
Almost one-third of your score is based upon how much debt you have versus how much credit, creditors have been willing to give you. If there is a high credit utilization rate, then your credit score is automatically lowered.
The lower your credit score, the higher is the interest rate.
How can you improve your ratios?
There are steps you can take to improve your ratios. Boost your monthly income, which would inevitably lower both your front-end and back-end debt-to-income ratios.
You can also ease down on your monthly debt burden by paying down your credit card bills or by making extra payments on monthly debts like the student loan or auto loan payments.
What’s essential to note from this article is to have a clear understanding of the underlying difference between debt-to-income and debt-to credit. Many people get confused between the two ratios as they sound similar.
The debt to income ratio is obtained by dividing the amount of the total debt with the total income. Whereas, debt-to-credit ratio is the amount of debt you carry versus the credit that’s available to you.
So, have a clear understanding and try to have within the accepted ratios to lead a good financial life.