You may have heard the term “debt to income ratio” and have a vague idea of what it may mean. Lenders use the debt-to-income ratio as a device to evaluate whether you are a good candidate for a loan.
So how much debt is too much debt? For the individual, the answer may depend on your income level, lifestyle, and risk tolerance. The debt load one person carries might be too high for another person. But lenders will have a slightly different view.
For lenders like banks, credit unions, and mortgage brokers, the debt-to-income ratio is a significant financial measurement to determine an individual’s creditworthiness. But it can also be an important way to look at your debt and how it compares to your income to see if you’re in too much debt.
In this article, we’ll explore what the debt-to-income ratio is, how it’s calculated, and why it matters for your financial health.
The Debt-to-Income Ratio
One of the key tools lenders use to assess a borrower’s financial health is their debt-to-income ratio (DTI). This simple financial metric compares a potential borrower’s monthly debt payments to their monthly income, providing a quick snapshot of how much debt they are carrying relative to their earning power. This includes credit card and medical debt.
In simple terms, it is the percentage of a person’s monthly income that goes towards paying off their debts. The ratio is calculated by dividing the total monthly debt payments by the gross monthly income. It is used by lenders to assess whether you, as a borrower, can afford to repay debt on time or not. If you have a high DTI ratio, then you are likely not a great candidate for a loan. According to Citizens Bank, a high score would be any ratio above 43%.
The Effect of Your Debt-to-Income Ratio on Your Financial Life
A high DTI ratio can be a major obstacle to getting loans, credit cards, and mortgages. A high ratio indicates that a significant portion of a person’s monthly income goes towards repaying debt, leaving them with lower disposable income and less money to take on another payment.
If you have a high ratio, your inability to obtain loans like these can increase your stress as you struggle to maintain your standard of living. You are at a greater risk for loan defaults, which can have a significant and long-term effect on your credit score and financial standing.
Ideally, a debt-to-income ratio of 36% or less is considered healthy. This means that a person’s total monthly debt payments should not exceed 36% of their gross monthly income. A lower DTI ratio indicates that a person has more disposable income to cover their living expenses and other financial obligations.
Ways to Lower Your Debt-to-Income Ratio
The first step in lowering your debt-to-income ratio is to figure out what it is. This can be done by dividing your monthly debt payments by your monthly income. A low DTI ratio result of 36% or less is best.
The most obvious way to lower your DTI ratio is to pay off debt and do it faster. Focus first on paying off unsecured debt with high-interest rates like credit cards.
It’s also important to avoid taking on more debt while attempting to lower your debt. Try to make sure to adjust your budget to avoid any new expenses and minimize spending on discretionary items.
Another way to lower your debt-to-income ratio is to increase your income. Consider taking on a part-time job or increasing hours at your current job if you get overtime pay or finding ways to monetize a hobby or skill. This will increase the denominator in your DTI ratio calculation, making it easier to achieve a lower ratio even with the same amount of debt. However, be sure to factor in any taxes or expenses related to generating additional income when calculating your debt-to-income ratio.
Schedule a Consultation with a St. Cloud Bankruptcy Attorney
As you now know, the debt-to-income ratio is a decisive financial metric that lenders use to assess an individual’s creditworthiness. If you find your ratio is less than ideal, then this may be a sign you are not in good financial health. Added to this, you may already be dealing with stress as you struggle to keep up with monthly payments and daily cost of living expenses.
At Kain + Henehan, we understand this struggle and are bankruptcy attorneys who can help you evaluate your situation. If filing for bankruptcy is worth considering, we can explain why and then help you file properly. We have offices in St. Cloud and Mendota Heights and serve clients in the area as well as the Twin Cities and all over Minnesota.
Facing the prospects of bankruptcy can be scary enough; meeting with us should not be. We are here to make you comfortable from the very first phone call. Contact Kain + Henehan by calling (612) 438-8006 or filling out the online form to schedule a consultation with a bankruptcy attorney. We make our process easy, and we look forward to meeting you.