What is your debt to income ratio? Also known as the DTI, this is the relationship between your debts and your income.
This is important because creditors and lenders rely on this data. They use it as a basis to approve your application for a loan or a new credit account. It gives them an idea if you can afford to pay off the debt that you want to borrow.
If your ratio is too high, that means you might not be able to afford all your payments. This makes you a high-risk borrower. The creditor or lender will then give you a higher interest rate to protect themselves. Either that or they will not approve your loan application. They wouldn’t want the headache that you’ll bring in case you can’t afford to pay off what you borrowed.
But how can you calculate your debt to income ratio? Here’s an example.
Let’s say your monthly debt payment is $1,500 and your income is $5,000. Your DTI ratio is 30%. It means 30% of your income goes to your debts.
Is that a good ratio? Experts believe that a good debt to income ratio is 36% or less but for mortgages, it’s 43%. Of course, the lower the ratio, the better it will be for your loan or credit application.
So if you have a 30% DTI ratio, that’s good for you. But what if you have a high ratio?
Steps to improve your debt to income ratio
Fortunately for you, you can lower your debt to income ratio. You don’t even need a professional to make it happens. It only takes 3 simple steps to do it.
Step 1: Increase your income
Your income is one of the factors used to calculate your DTI ratio. Naturally, increasing your income will improve your ratio. Let’s take the example given earlier as an example. If you get a side gig that will increase your monthly earnings by $1,000, that will make your total paycheck $6,000. Even if you still have the same amount of debt, your debt-to-income ratio now will be 25%. That is way below the ideal, which is 36%.
Now the challenge is to find the strategies that will help you increase your income. There are a lot of options that you can choose from. You can start by asking your employer for a raise. There’s no guarantee that they will agree but you wouldn’t know unless you ask.
There are online freelancing jobs that you can rely on too. Even simple data entry or typing jobs will add to your monthly cash flow. Getting a second job is also another option that you can use. These two options will make you work harder to increase your income. But it will be worth it because it will also give you financial security. In case you lose your job for some reason, you have another source that you can rely on.
If you want to increase your income without having to exert more effort, set up a passive source of income. For instance, if you have an extra room or garage that you can rent out, that can be an effective way to earn more without adding to your workload.
Step 2: Pay off debt
If you can add to your income, you can also pay off your debt to improve your debt-to-income ratio. The more you can lower it, the better it will be. Of course, this will depend on what type of debt you are paying for.
If you are paying a fixed price for your debts, this won’t matter that much. It will only matter once you completely pay off the debt. For instance, part of your $1,500 debt payment is a personal loan that requires you to pay $300 each month. If you completely pay off that balance, your monthly recurring debt payment will go down to $1,200. This move will make your DTI ratio go down to 24% from 30%.
Having a variable type of payment will affect your DTI ratio differently. The best example of this is your credit card payments. Creditors determine your monthly minimum payment based on your balance and the interest rate. How? Whatever your balance is, a finance charge will be added to it. This will determine your minimum monthly payment. Now the higher your payments are, the lower the finance charge will be – including the minimum payment. That could affect your monthly debt payment – even if it’s very minimal.
Step 3: Avoid new debt
Of course, paying off the debt will not be enough if you want to make a difference in your debt to income ratio. This is why it’s also important for you to avoid debt too. At least, stop borrowing more until you’ve managed to bring your DTI ratio to a more acceptable level.
And even if you have successfully done that, you still need to change how you use credit. You have to be smarter with it. Like before you apply for a new loan or credit account, make sure you know the important questions to ask before you borrow. This will ensure that you will not be reckless with credit. Think about it carefully and make sure you know how you’ll pay it back. That way, you won’t endanger the debt to income ratio that you’ve worked so hard to improve.
Why you need a good debt to income ratio
There are a couple of reasons why you need to have a good DTI ratio.
Easy loan approval
As mentioned, your debt-to-income ratio is one of the things that your creditors and lenders will look at. If they can see that you have an acceptable ratio, they don’t have to think twice before they decide to approve your application. They know that you can afford to pay off your debts.
Lower interest rate
Having a good DTI ratio will also make you a low-risk borrower. That means the lender and creditor won’t have to give you a high-interest rate to protect themselves from the possibility that you won’t pay them back. This means the whole debt will not cost you a lot of money. Although you still have to pay interest, it will not be a huge dent on your wallet.
Better living conditions
Finally, have a good debt to income ratio will help you maintain better living conditions. According to a report, the necessary living wage in the country is $67,690. The lower you have to spend, the more unappealing your lifestyle will be.
This is why you have to make sure your debt payments won’t limit what you can spend on yourself and your family. You have to remember that the more debt you have to pay each month, the less money you have to spend on your preferred lifestyle.