One of the easiest ways to get a picture of your current financial standing is to calculate your debt-to-income ratio. Monitoring your debt-to-income ratio can help you manage your personal finances, while lenders will often use it when considering your credit status.
What is a debt-to-income ratio?
Your debt-to-income ratio compares the amount of your debt (excluding your mortgage or rent payment) to your income. The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20).
Why is monitoring your debt-to-income ratio important?
Keeping track of your debt-to-income ratio can help you avoid "creeping indebtedness," or the gradual rising of debt. Impulse buying and routine use of credit cards for small, daily purchases can easily result in unmanageable debt. By monitoring your debt-to-income ratio, you can:
- Make sound decisions about buying on credit and taking out loans.
- See the clear benefits of making more than your minimum credit card payments.
- Avoid major credit problems.
Creditors look at your debt-to-income ratio to determine whether you're creditworthy. Letting your ratio rise above 20 percent may:
- Jeopardize your ability to make major purchases, such as a car or a home.
- Keep you from getting the lowest available interest rates and best credit terms.
- Cause difficulty getting additional credit in case of emergencies.
Debt-to-income ratios are powerful indicators of creditworthiness and financial condition. Know your ratio and keep it low.
How do I calculate my debt-to-income ratio?
The first step in calculating your debt-to-income ratio is determining your monthly take-home pay, which is the amount you earn after all deductions. If you're paid every other week, multiply your take-home pay by 26, then divide by 12. This is your monthly take-home pay. If your income is inconsistent, estimate your monthly take-home pay by dividing last year's annual take-home pay by 12.
If you get paid weekly, take your weekly pay and multiply it by 4.3 for the monthly amount.
If you get paid every other week, take your pay and multiply it by 2.15 for the monthly amount.
Remember to include:
- Regular income from alimony and child support.
- Conservative averages of bonuses, commissions, and tips.
- Earnings from dividends and interest.
Here is an example. Juliana's take home pay is $1350, every two weeks. By multiplying $1350 by 26 and dividing by twelve ($1350 x 26)/12, we have here monthly income from her salary: $2925.
She also receives $400/month in child support. $2950+400 = $3350. Juliana's monthly income is $3350.
The second step is adding your total monthly debt payments. Add your current minimum monthly payments for all credit accounts and loans, excluding mortgage or rent payments. Be sure to include:
- Car payment(s).
- Loan payment(s) (furniture, appliances, etc.).
- Bank/credit union loan(s).
- Student loan payment(s).
- Other loans/credit accounts.
- Credit card payments.
- Payment for past medical care.
Juliana has the following monthly debt payments: Car payment ($212), student loan ($220), credit card payment ($625). Her total debt payments are $212 + $220 + $625 = $1057.
Now it's time to calculate your debt-to-income ratio. Divide your total monthly debt payment by your total monthly take-home income from all sources. The result will be your debt-to-income ratio. Total monthly debt payments divided by monthly take-home pay equals your debt-to-income ratio percent.
Let's see what Juliana's debt to income ratio is: $1057/$3350 = 31%.
Is my debt-to-income ratio acceptable?
The lower your debt-to-income ratio, the better your financial condition. You're probably doing OK if your debt-to-income ratio is lower than 19%. Though each situation is different, a ratio of 20% or higher is a sign of a credit crisis. As your debt payments decrease over time, you will spend less of your take home pay on interest, freeing up money for other budget priorities, including savings.