Your debt-to-income ratio is the portion of your income that's spent paying off a mortgage, credit cards and other debts. Some lenders and creditors may consider the ratio as important as your credit score because it indicates whether you have enough extra income to pay off new loans and lines of credit.
Recommended Ratio
Financial professionals generally recommend that people not have total debt obligations that take up more than 36 percent of their gross income. Your gross income is the amount of money you earn before tax deductions. You should keep your debt-to-income ratio at this level because lenders and creditors consider the ratio when they review credit and loan applications. A high ratio could prevent you from getting a credit card or loan if creditors and lenders conclude that you're accumulating more debt than you can afford to repay.
Ratio Calculation
Creditors and lenders add up your monthly recurring debts to determine your debt-to-income ratio. Monthly recurring debts include car, mortgage, rent and student loan payments as well as any required minimum monthly payments for credit cards. Exclude groceries, utilities and other living expenses from the calculation. Divide the total of your monthly recurring debts by your gross monthly income and multiply that number by 100 to calculate your debt-to-income ratio. For example, someone who has a gross monthly income of $4,000 and monthly recurring debts that total $1,500 would have a debt-to-income ratio of 37.5 percent.
High Ratios
Some lenders approve loans even if borrowers' total monthly debts take up as much as 45 percent of their gross monthly income. However, borrowers should be leery of signing on to a loan if they have such a high debt-to-income ratio, especially if they don't plan to use the loan to pay down debt. Remember that the typical ratio doesn't include clothing, food and other living expenses. Therefore, taking out a loan when you have a 45 percent debt-to-income ratio can put you on a tight budget that would be impossible to maintain.
Considerations
Consider calculating your debt-to-income ratio by using your net monthly income instead of your gross monthly income. Your net income is your take-home pay, which is the money you receive after tax deductions. Calculating your debt-to-income ratio using your net income can provide a more realistic picture of how much money you have to spend. Your debt-to-income ratio shouldn't exceed 15 to 20 percent when it's calculated using your net income. The article recommends immediately cutting unnecessary expenses and reducing your debt if your ratio is close to 15 percent because you may be on the verge of taking on too much debt.
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