Debt to Income Ratio
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Debt to income ratio is a term you’re likely to hear when you apply for a loan or when you’re studying your credit. In many cases, consumers learn about their debt to income ratio when their credit application is turned down.
Your debt to income ratio is the percentage of your income that goes toward debt payments. So, for instance, if you earn $2000 per month and your total minimum debt payments each month are $200, your debt to income ratio is 10 percent.
To calculate your debt to income ratio, determine your monthly gross income (the amount you are paid before you pay taxes and other payments) and then calculate how much you owe in debt each month. Then divide this latter amount by your monthly gross income. The example above was calculated by dividing 200 by 2000.
When determining your debt to income ratio, you’ll use any debt you have related to:
- Auto loan
- Minimum credit card payments
- Student loans
- Personal loans
- Alimony, child support, and other financial judgments
What’s Considered a “Good” Debt to Income Ratio?
Though a range of debt to income ratios can be approved for loans, lenders typically look for a ratio of 36 percent or less. There are exceptions to that rule depending on the type of loan you are pursuing, but you should aim to keep your ratio at 36 percent or lower. This shows lenders you have enough wiggle room to pay back a debt, even if something expected occurs. Some lenders are stricter and look for a ratio in the 20s. Your best bet is to aim for a ratio as low as possible.
Your debt to income ratio has no direct bearing on your credit score. However, something called the “credit utilization score” does affect your credit and it’s linked to your debt. The credit utilization score accounts for 30 percent of your credit score and is the rate of available credit you’re using.
Keep in mind this is not the amount of credit you have or the debt you owe, it’s a combination of these two factors. If you have a credit card with a $1000 limit, and you owe $500 on it, your credit utilization rate is 50 percent. You’re using half of what you have access to.
When your utilization rate is 30 percent or less, your credit score is affected positively. Your income does not play a role in this calculation – it’s all based on the amount of credit you have available versus the amount you’re currently using.
Applying for and receiving more credit can improve your utilization rate, as long as you don’t use that credit. Conversely though, applying for more credit won’t help your debt to income ratio. The only way to improve your debt to income ratio is to pay down your debt or earn more money.
What Does It Mean If You’re Told You’re Maxed Out?
If you attempt to apply for a loan and you’re turned down or told not to bother because you’ll be rejected because you’re maxed out, it means your debt to income ratio is too high and/or your credit utilization rate is too high. In many cases, it means both.
When you’re barely making enough money to meet your monthly debt obligations and your credit cards are maxed out, you’re considered too much of a risk for lenders. Not only are you struggling to get by, you also have limited resources (credit), should you get into trouble.
It’s possible for someone to have a decent debt to income ratio but still be turned down for a loan if their credit utilization ratio is too high. This is because lenders know your debt to income ratio could change for the worse in the blink of an eye. If you lose your job, you lose your income, but your debt remains. The situation is even worse when the balances you’re carrying on your credit cards are high and there’s no credit cushion to get you through the loss of your job.
A high debt to income ratio also affects your ability to save. If you’re barely meeting your debt obligations, there isn’t much – if any – left to put into savings for an emergency.
Despite your debt to income ratio not having a direct effect on your credit, it weighs heavily on a lender’s decision to approve a loan. This can be frustrating if you’re applying for a loan and you have a high credit score. Many loan applicants feel cheated or wrongfully denied when they are turned down based on debt to income ratio, but have a solid credit score.
Unfortunately, the only option you have in this case is to deal with your debt situation and ensure it doesn’t eventually affect your credit.
What Can You Do?
It’s important to realize if your debt to income ratio is high and your credit hasn’t suffered, it might only be a matter of time before your score drops. If you’ve stretched yourself too thin, just one small, unexpected emergency could get you into trouble.
More importantly, if your debt to income ratio is high and your struggles have affected your credit, you need to take action to get your situation under control. Unfortunately, it’s nearly impossible to get back on track concerning your credit if your debt to income ratio is less than ideal. You simply don’t have the money available to get handle on your debt.
A situation in which you are struggling month to month to meet payment obligations – or you’re no longer able to meet those obligations – and you’re debt to income ratio is high is a sign that things are about to go downhill fast. It’s also a strong indication that bankruptcy might be your best option.
The best thing you can do is speak to a financial expert who can assess your situation and determine if bankruptcy is your best option. In many cases, a drastic solution in the present can offer the best long-term benefits.
For more information or to schedule a consultation to review your financial situation, contact us at 1.800.220.4318.