Sometimes debt is unavoidable, such as when you owe large medical bills or are paying for college through student loans. Other times, however, people fall into debt because of poor financial decisions, such as overspending on credit cards or purchasing a home they could not afford. Your debt-to-income ratio is the amount of debt you owe compared to the amount of money you make, and it can help you in making financial decisions.
Calculate the Ratio
It is relatively easy to calculate your personal debt-to-income ratio. Add together your fixed monthly expenses, such as auto payments, child support payments, credit card payments, mortgage or rent payments and any other monthly debt obligations. Divide that total by your total gross monthly income. For example, if your monthly expenses total $1,000, and your gross monthly pay is $4,000, your debt-to-income ratio is 25 percent (1,000 divided by 4,000 equals .25, or 25 percent).
Good Debt-to-Income Ratio
Your debt-to-income ratio should be less than 36 percent, according to Lending Tree and U.S. News and World Report. If you have a higher debt-to-income ratio than that, you might be in financial trouble. If you are slightly above 36 percent, your debt-to-income ratio is manageable with a few changes in your personal life to reduce the ratio. If your debt-to-income ratio is more than 50 percent, you might consider seeking professional help to reduce the number.
Consequences of a High Debt-to-Income Ratio
A high debt-to-income ratio has a number of consequences. If you are in a lot of debt, your credit score likely will be negatively impacted, especially if you have missed payments or made late payments. Some lenders will not approve you for a loan for a home or car if your debt-to-income ratio is high, regardless of your credit score. A high debt-to-income ratio is an indication you may not have enough money to cover your expenses.
Tips to Reduce Debt-to-Income Ratio
You can improve your debt-to-income ratio in two ways: reduce your expenses and/or increase your income. A "Thrifty Living" report on the University of Illinois Extension website suggests ways to increase income include selling items you don't need, providing a service at a price or adding a part-time job. Reducing expenses is often easier than increasing income. According to the Personal Finance Analyzer website, there are a number of small changes you can make to help reduce expenses: Downsize your house to decrease your monthly rent or mortgage costs, or find a roommate to move in and share the housing expenses. Stop overspending on your credit cards. Lower your utility bills by using less energy and electricity in your house and getting rid of unnecessary utilities, such as cable TV. Eliminate other bills, such as gym memberships or magazine subscriptions, and shop at discount grocery stores. Move to a less expensive cell phone plan. Transfer your credit card balances to new cards with lower interest rates, and use the money you save to pay off the balance faster. Financial adviser Dave Ramsey suggests on his website that you can incorporate the envelope system into your spending habits: Designate one envelope for each regular spending category, such as entertainment or groceries. Put a set amount of cash in the envelope for each category every month, and spend only that set amount. When the cash is gone, you cannot spend in that category again until the next month. This helps you avoid overspending.
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