A good measure to determine if your debt is getting out of control is determining what your debt-to-income (DTI) ratio is. If your DTI ratio is close to or higher than 36% then you should be working to reduce it.
Lenders use DTI to determine if a potential customer can afford to take on extra debt. The preferred maximum DTI varies among lenders, however, 36% is often used as the maximum.
So how do you determine your debt-to-income ratio? You first have to determine what your monthly payments are to service your debt. For example, let’s assume your monthly debt is as follows:
Car loan = $300
Mortgage = $1,100
Credit cards = $500
Other debts = $400
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Total debts = $2,300
Now let’s assume you earn $60,000 per year, which equates to $5,000 per month. You debt-to-income ratio is $2,300 divided by $5,500 which equals 0.46 or 46%. This is very high and a person in this situation needs to take quick action to reduce their debt.
So what can you do to reduce your DTI ratio? You can take the following steps:
- Increase your monthly payments to service your debts. Applying extra payments to the principle will lower your overall debt faster.
- Stop taking on additional debt. The more debt you take on, the higher your DTI ratio.
- Delay large purchases until you have more savings. The larger your down payment, the lower your monthly cost, thus decreasing your DTI ratio.
- Calculate your DTI ratio monthly to determine if you are making progress.
- Earn extra income by finding a new job or additional work (part time) to pay down your debt faster.
Keeping your DTI ratio at a manageable level is one of the foundations of good financial health. A manageable DTI ratio also gives you peace of mind that you can handle your financial responsibilities and will help you qualify for credit to purchase things you really want, like a new home.