How to Use Ratios for Credit Decisions

Too many people take a haphazard approach to managing personal finances and determining how much debt they can afford. There is a better way. There are several debt ratios you can use to help make a variety of personal financial decisions. While you won't guarantee yourself trouble-free finances simply by using these ratios, you can use them as a guidepost for making smart debt decisions.

Instructions

1

Calculate your basic financial information. You can't use a ratio until you have the raw data, so you'll need to start there. You should first determine what your monthly income is, then how much you pay in monthly bills, including credit cards, car payments, mortgage, rent and any other recurring expense.

2

Determine your base debt-to-income ratio. Once you know how much you earn each month versus how much you pay, you can calculate your debt-to-income ratio. If, for example, you earn $10,000 per month and pay $4,000 in bills, you have a debt to income ratio of 40 percent.

3

Calculate your debt utilization ratio. You should also determine how large a balance you carry on each of your credit cards versus your credit limit. This credit-utilization-ratio is an important part of your credit score, and lowering it increases your score and chances of getting credit. For example, if you have a card with an $8,000 limit and carry a balance of $1,600, you have a 20 percent debt utilization ratio on that card.

4

Calculate what you can afford. Erin Peterson of Bankrate reports that you want to keep your debt-to-income ratio below 36 percent when shopping for a home or searching for an apartment. This means that if you currently earn $10,000 per month and have a 20 percent DTI, or $2,000 per month in bills, you can afford to pay another $1,600 per month in mortgage or rent and still be on a good financial footing.

5

Lower your balances. Kimberly Lankford, of Kiplinger, reports that you should keep your debt utilization ratio on each of your credit cards below about 25 percent of your credit limit in order to get the best credit score and loan rates available. If you're considering a new loan, try to pay off any balances below this level before you apply for it.