Keep an Eye on Your Debt-to-Income Ratio
When you reach a point when it seems that most of your money is going towards paying down your debt, you probably have an upside down debt-to-income ratio (DTI). Your DTI compares the total amount of your monthly debt payments to your income. The higher your DTI, the more of your income is being siphoned off to pay your debt, putting you under greater financial stress. At that point, you should be doing everything possible to reduce your debt payments or find a way to bring in more income.
How to Calculate Your Debt-to-Income Ratio
To calculate your DTI, add all your debt payments together, including your mortgage or rent, credit card payments, car payments and student loan payments. Next, add your sources of monthly income. Divide your total monthly debt payment by your total monthly income and you have your DTI ratio.
Total debt payments/ Total monthly income = Debt-to-income ratio
Why Your Debt-to-Income Ratio is Important
In terms of managing your personal finances, your DTI ratio is a critical number. If it gets too high, you will feel the financial pinch of having more money go towards debt than savings. It also means you have less available to cover any unexpected expenses, which will make you more reliant upon debt should you need the money.
Should you need to obtain a loan or increase your credit limits, your DTI is an indication to lenders of your risk of default. Although your DTI is not a part of your credit score, lenders often view it as a stronger indicator of your credit risk. This is especially true when applying for a home mortgage. While every lender has their own DTI requirement, your chances of being approved decline significantly when it is above 40 percent. Some lenders may require a lower DTI, especially if your credit is less than excellent. For the best chance of getting approved, your DTI should be no higher than 36 percent with about 28 percent going towards your mortgage payment. That essentially means you very little non-mortgage debt.
How to Lower Your DTI Ratio
You can lower your DTI in one of two ways: Reduce your debt or make more money. Depending on your circumstances, one may be more difficult than the other to achieve. However, reducing your debt should always be a priority, regardless of how much money you make.
The first step in reducing your debt is to stop creating more stop using your credit cards. Then prioritize your spending to create more cash flow that can be applied to paying down debt even if it just an extra $50 a month. Stop or reduce your spending on non-essential expenses, such as leisure activities, dining out and buying new clothes. Target your smallest balances first and, as they are paid off, apply all your extra cash flow to the next highest balance.
If you anticipate a salary increase or bonus, it can certainly help you to reduce your DTI as long as you cap your spending and apply the extra cash flow to your debt. But, there are ways to increase your income enough to make an even bigger dent in your DTI. You can try to get some overtime hours; you can work a side gig 10 to 20 hours a month; or you can become a freelancer.
Certainly, any extra cash you receive from a tax refund or a garage sale should go towards your debt. Your goal should be to reduce your DTI to below 25 percent and keep it there.