Between credit cards, student, home, and auto loans, most Americans have some sort of debt.
As you work to gain control of your finances, you have to know what can be negatively impacting you and keeping you from getting where you want to be.
Whether you have plans of owning a home, a car, or simply want to open a new credit card account, knowing your debt-to-income ratio(DTI) will help you know just where you stand and how creditors may view you.
What is a debt-to-income ratio and how is it calculated?
A debt-to-income ratio is a number used to measure a person’s ability to manage their debt. This number is calculated using two key pieces of financial information: your debt and your income. By taking your total monthly debt and your total monthly income, which includes any money earned prior to taxes and deductions, you can determine your debt-to-income ratio.
In another example where the total debts are higher than $1,500 and income is still $4,000, you see an increase in the DTI. If you have monthly debt payments equal to $2,000, and your gross monthly income equals $4,000, your debt-to-income ratio will be 50%.
What is the ideal debt-to-income ratio?
If you aren’t thinking about applying for an auto or home loan, opening a credit card account, moving into a new apartment, or doing anything else that requires someone to review your credit and finances, you may not care too much about your DTI. But when you are seeking credit, part of the application process may include a thorough review of your finances. Even though it will vary, every creditor and lender has certain criteria that applicants must meet in order to approve an application, so they might be interested in examining your DTI to determine if you should be approved.
Since this number gives insight into how you manage your debt, specifically your ability to repay your debt, the higher your DTI, the more likely you are to be denied. Creditors will look for borrowers who have a debt-to-income ratio no higher than 43%. This means that if your monthly income is $4,000, your total monthly debt payments should be equal to no more than $1,720. Although 43% is acceptable to most creditors, a lower DTI is even better.
Improving your debt-to-income ratio
If your DTI is above 43%, you have the power to change it. Since your monthly debts and income are the two important factors used to determine your DTI, there are a number of ways you can lower your DTI and get in a better position financially.
If you want to improve your debt-to-income ratio, one thing you can do is reduce the total amount of debt you owe. If you have taken out a loan for $5,000, your monthly loan payment will be included in your debts used to calculate your DTI. By making extra payments on your loan, you will be able to pay off the loan faster and reduce the amount of debt owed.
Additionally, if you want to improve your DTI, you can also avoid adding to your current amount of debt or increase your monthly income by taking on a hiring paying full-time job, part-time job, or gig.
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