When it comes to personal finance, there are many terms and ideas that can significantly impact our finances and our day-to-day lives. Being financially healthy is just as critical to our futures as maintaining our physical health. Still, while it’s usually pretty straightforward to tell if you’re physically fit, financial health can be a bit murkier.
Debt is a fact of life for most people, whether it’s in the form of credit card debt, a car loan, or a mortgage. Few people these days make it through life without ever taking on debt. But how do you know how much debt is too much? How vital is maintaining an appropriate amount of debt for your financial situation? And perhaps most importantly, what can you do if you have too much debt?
A simple calculation known as the debt-to-income ratio can help answer these questions. The term is lesser-known than some other standard personal finance terms but is crucial to understanding your financial health.
Just like it sounds, the debt-to-income ratio is a measurement of how much debt you have relative to your income. To find it, add up all your monthly debt payments, including your home or car loan, student loans, and credit card payments, plus any other debts you might have. Then divide that number by your gross monthly income, the amount you earn before taxes. You can also find special calculators online that will do the math for you.
Everyone’s financial situation is unique, but generally speaking, the lower your debt-to-income ratio, the better. Lower numbers mean that you have less debt relative to what you’re bringing in, which suggests that it will be easier for you to pay off that debt. According to the Consumer Financial Protection Bureau, 43% is the highest ratio you can have and still get a qualified mortgage, a more stable mortgage loan category.
Why Does It Matter?
Debt-to-income ratios play a significant role in determining whether or not you’ll qualify for a mortgage or other type of loan. Essentially, lenders want to know if you make enough money to pay off your existing debts and any additional debt they might offer you. If your ratio is too high, they might feel that you’re more likely to default on payments or offer you a lower loan amount.
The quickest way to improve your debt-to-income ratio is by paying down debt. Of course, this is easier said than done, especially if you have a lot of debt but don’t have the salary to keep up with it. But it’s not an impossible task for most people. Using techniques like the snowball method can help you pay down debt over time. Creating and sticking to a budget will help rein in spending that cuts into your ability to pay debts and prevents racking up more. Another way to improve your ratio is to increase your income, perhaps by asking for a raise at work, seeking a new job that pays better, or taking a side gig to earn more money until you can pay down some debt.
Debt-to-income ratios are one of many calculations that have a major impact on your ability to make certain financial and lifestyle decisions. Keeping the amount of debt you carry as low as possible can help keep your ratio low and set you up for success down the road. And even if you already have a high ratio, you can work toward bringing it down, armed with the right knowledge.