By James Lambridis Founder/CEO DebtMD
Everyone has bills to pay; this is a fact of life. Mortgage, auto loan, car insurance, utilities, credit cards, medical bills, student loans, the list can go on forever. It is when we let our bills affect our quality of life that it becomes a serious problem. You know your finances better than anyone, but when figuring out whether you need to lower your overall debt balances, it starts with calculating your Debt to Income Ratio (DTI).
Debt to Income Ratio
DTI is the percentage of your gross income (income before taxes) that goes to paying your debt obligations. Debts typically included in this calculation are your monthly mortgage or rent payment, minimum credit card payments, auto loan payments, student loan and personal loan payments, monthly alimony or child support, and anything else that shows up on your credit report. Along with your credit score, DTI is factored into most lending decisions by banks and financial institutions to gauge your creditworthiness as a borrower. While most people are much more concerned with having a good credit score, DTI should not be overlooked.
To give a concrete example, let’s say your monthly income is $5,000 before taxes. You pay $1,000 per month for your mortgage, $500 per month for credit card bills, and another $300 per month for an auto loan. Your DTI would be:
$1,000 +$500 + $300 = 36%
Most lenders would consider 36% a decent DTI. While there is room for improvement, assuming your credit score is at a reasonably good level, with a DTI of 36% you would have no issue securing a mortgage, getting approved for an auto loan, or obtaining a new credit card.
According to Wells Fargo, a 35% DTI or below is viewed as favorable. Below you can find guidelines used by Wells Fargo to make a lending decision. While every lender might have their own standards, they should not vary significantly from the ones below.
35% or less: Good DTI. Relative to your income, debt is at a manageable level.
36% to 49%: Opportunity to improve. Debt is being managed adequately, but you may want to consider lowering your DTI.
50% or more: Take action;. You may not have much money left over to save or spend, and your borrowing options will be limited by lenders.
What Can I Do To Lower My DTI?
There is no secret formula for lowering your debt to income ratio. However, there are two effective ways to improve your DTI: (1) increasing your income or (2) decreasing your expenses. Doing both at the same time will work wonders for your DTI. To increase your income, you should try picking up more hours/shifts at your current employer if possible, or try working a side gig in your free time. To decrease your expenses, if you have enough equity to do so, refinancing your mortgage to lower your monthly payment can be helpful. You can also look into refinancing your auto loan to do the same. When it comes to credit card debt, it can become tricky. There are options to help accelerate the payoff of credit cards, such as a debt consolidation loan, credit counseling, or debt settlement. Before choosing one of these options, be sure to educate yourself on them to make sure it is the best option for your unique financial situation.
Telltale Signs You Have Too Much Debt:
Calculating your debt to income ratio is the surest way to determine whether your debt is a serious problem. However, here are some more practical signs that you should look into lowering your overall debt load:
- Your debt balances won’t go down despite making payments each month
- You have no money left over at the end of each month
- You have less than $500 in savings
- You have to resort to the use of credit cards for basic necessities such as groceries, clothing, and utility bills
- You have used your credit card for a cash advance
- Your debt has affected your relationships with a significant other/family member
- You have recently been late on a debt payment
- You credit score has gone down
If you are experiencing one or more of the above in your personal/financial life, it may be time to hunker down and get your debt to a more manageable level. In the end, if your debt is negatively affecting your quality of life and hindering the things you wish to do, it’s time to create a plan to pay it off. One thing to remember, doing nothing is the WORST thing you can do. Making minimum payments is the equivalent of a hamster spinning on the wheel, you will never get anywhere. In order to make a real dent, you should try to double, or even triple the minimum payments. It is only then when you will see progress. If this is not doable, you should look into debt consolidation.
Know the Difference: Good Debt vs Bad Debt
We have established that at some point in your life, you will have debts to pay. Keep in mind that not all debt is bad. The more good debt that you have, the more money that will remain in your pocket, and the better your overall financial health will be. The key to achieving your financial goals is being able to distinguish the difference between the two and having the right allocation of good debt and bad debt on your books.
Good Debt - Good debt is used to purchase something that grows in value such as a home, or an investment that can pay dividends in the future like a college education. These debts always have lower interest rates that are usually fixed and don’t fluctuate. Other examples of good debt are home equity loans or lines of credit as well as small business loans. If the debt is tied to an asset (which can appreciate in value), this usually means it is a good debt. If the debt can either directly or indirectly help you earn income at some point down the road, you can classify it as good debt as well.
Bad Debt - Bad debts will almost always have higher interest rates that can sometimes fluctuate (also known as a variable rate). Examples of bad debts are long term auto loans, unsecured personal loans, and credit cards. Staying away from bad debts is key to ensuring that your DTI remains at a healthy level, and more importantly, keeping your hard earned money in your pocket. If you find yourself in a difficult financial situation with high debt balances, you should focus on paying down your bad debt first. Once your bad debts are cleared, you will find you have much more cash flow and your quality of life will be that much better.
Things to Remember
Debt isn’t always a bad thing and it’s not a crime to owe money. If that were the case, we would all be in jail. With that being said, it’s important to stay on top of your debt situation, and take the necessary steps to lower your debt when necessary. Also, know the difference between good and bad debt and the implications of having each of them. If you are hampered by credit cards, medical bills, or student loan debt, and want to look into options to pay it off faster, use our Smart Debt Analyzer. You can also find more useful tips and advice in our Blog.
- Know how to calculate your DTI as well as the guidelines that lenders use to make lending decisions.
- Know when to realize that you have too much debt and need to do something about it.
- Keep bad debt at a minimum.