The Basics of Debt-to-Income Ratios
For an individual, a debt ratio describes the percentage of your income that goes to debt payments. You’ll often see this described as a Debt-to-Income Ratio.
Your ratio is usually calculated based on your gross income. So if your salary is $3,000 per month, and your total debt payments every month are $300, your debt ratio is 10%. (3000 divided by 300 is 10).
Calculating your ratio
You need to determine your monthly gross income first. That’s your income before taxes, not your take-home pay. Then determine what your monthly debt payments are. Be sure to include credit cards, auto loan, mortgage, etc. Then simply divide your total debt payments by your monthly income gross.
Here’s an example:
Mortgage: + $1100
Auto loan: + $300
Credit card payments: + $200
Monthly debt total = $1600
Monthly income gross / $4200
Debt ratio = 38%
What should my debt ratio be?
In the example above, the debt ratio of 38% is a bit too high. Mortgage lenders generally require a debt ratio of 36% or less. Some government loans allow a debt to income ratio that goes up to 41% or even 43%, but most experts and conventional lenders agree that 36% is the highest debt ratio a consumer should have.
How does my debt ratio affect my credit score?
30% of your credit score is based on your credit utilization rate. That’s the amount of available credit you are using: if you have a credit card with a $10,000 balance and you owe $5,000 on it, your utilization rate is 50%. Generally, your utilization rate should be 30% or lower to avoid having a negative effect on your credit score, but clearly the lower your utilization rate, the better. Your credit score doesn’t consider your income at all, so your overall debt ratio is not part of the calculation.
How do I optimize my debt ratio?
First, get an accurate calculation of your debt ratio. We’re not talking about your credit utilization rate here, so getting more credit won’t help. The only way to bring that rate down is to pay down your debts or to increase your income. We caution you to avoid employing short-term tricks to lower your ratio; some people get a forbearance on their student loans to lower their debt ratio, but this change will only be temporary, so your ratio won’t truly be accurate. Your ratio is a tool that tells you and your lender how much debt you can afford. If you hide debts or “game” the calculation, you’re only setting yourself up for failure. Instead work to pay off debts and increase income.
What is the optimal debt ratio for me?
Long term, the answer is “as low as you can get it.” If you’re trying to get a loan to purchase a home, 36% is the most common goal. If you don’t have a significant down payment saved up (20% of the total purchase price of the home), then 31% is a better target.