Keeping your debt at a manageable level is one of the foundations of good financial health. But how can you tell when your debt is starting to get out of control? Fortunately, there's a way to estimate if you have too much debt without waiting until realize you can't afford your monthly payments or your credit score starts slipping.
Your debt-to-income ratio (DTI) is a percentage that compares your monthly debt expenses to your monthly gross income. To calculate your debt-to-income ratio, add up all the payments you make toward your debt in an average month. That includes your monthly credit card payments, car loans, other debts (payday loans, investment loans) and housing expenses — either rent or the costs for your mortgage principal, plus interest, property taxes and insurance (PITI), and any homeowner association fees.
Next, divide your monthly debt payments by your gross income per month (that’s your income BEFORE taxes are deducted). Multiply that number by 100 to get your debt-to-income ratio as a percentage.
To calculate your debt-to-income ratio, divide your monthly debt obligations by your monthly gross income.
For example, if you pay $400 on credit cards, $200 on car loans and $1,400 a month in rent, your total monthly debt commitment is $2,000. If you make $60,000 a year, your monthly gross income is $60,000 divided by 12 months for a total of $5,000 a month. Your debt-to-income ratio is $2,000 divided by $5,000, which works out to 0.4 or 40%.
To put it simply: Because it’s important to lenders. Banks and other lenders study how much debt their customers can take on before those customers are likely to start having financial difficulties, and use this knowledge to set lending amounts. While the preferred maximum DTI varies from lender to lender, it’s often around 36%.
If your debt-to-income ratio is close to or higher than 36%, you may want to take steps to reduce it:
Keeping your debt-to-income ratio low will help ensure that you can afford your debt repayments and give you the peace of mind that comes from properly handling your financial responsibilities. It can also help you be more likely to qualify for credit for the things you really want in the future.
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