Lower Your Debt-to-Income Ratio
Your debt-to-income ratio indicates the percentage of your income goes toward paying your debt each month. The lower your debt-to-income ratio, the better because it means you don't spend much of your income paying debts. On the other hand, a high debt-to-income ratio means more of your income is spent on debt, leaving you with less money to spend on other bills or save.
You can calculate your debt-to-income ratio by adding up your monthly debt payments, including credit cards and loans, and then dividing that number by your monthly income. Multiply the result by 100 to get a percentage. For example, if you spend $1200 each month on debt and have a monthly income of $4,000, your debt to income ratio would be 30%.
High Debt-To-Income Ratio
If your debt-to-income ratio is more than 50%, you definitely have too much debt. That means you're spending at least half your monthly income on debt. Between 37% and 49% isn't terrible, but those are still some risky numbers. Ideally, your debt-to-income ratio should be less than 36%. That means you have a manageable debt load and money left over after making your monthly debt payments.
Impact of a High Debt-to-Income Ratio
A high debt-to-income ratio can have a negative impact on your finances in multiple areas. First, you may struggle to pay bills because so much of your monthly income is going toward debt payments.
A high debt-to-income ratio will make it tough to get approved for loans, especially a mortgage or auto loan. Lenders want to be sure you can afford to make your monthly loan payments. High debt payments are often a sign that a borrower would miss payments or default on the loan.
While your credit score isn't directly impacted by a high debt-to-income ratio, some of the factors that contribute to a high debt-to-income ratio could also hurt your credit score. More specifically, high credit card and loan balances, which may play a role in your high debt-to-income ratio, can hurt your credit score.
How to Reduce Your Debt-to-Income Ratio
There are times when having a high debt-to-income ratio makes sense. For example, it's not terrible to have a high ratio if you aggressively paying off your debt. On the other hand, if your ratio is high and you're only making minimum payments, that's a problem.
Generally, there are two ways to lower your debt-to-income ratio. First, you can increase your income. That could mean working some overtime, asking for a salary increase, taking on a part-time job, starting a business, or generating money from a hobby. The more you can increase your monthly income (without simultaneously raising your debt payments) the lower your debt-to-income ratio will be.
The second way to lower your ratio is to pay off your debt. While you're in debt repayment mode, your debt-to-income ratio will temporarily increase because you're spending more of your monthly income on debt payments. That's because a higher percentage of your income will be going toward debt.
For example, if your monthly income is $1,000 and you currently spend $480 on debt each month, then your ratio is 48%. If you decide to spend $700 a month on debt payments, then your ratio would increase to 70%. But, when you've paid the debt all the way off, your ratio would drop to 0% because you'd no longer spend your income on debt.