One of the biggest contributing factors to the financial issues many face today is debt. People from all income brackets tend to have too much debt, so most of their income goes towards debt servicing instead of towards a higher quality lifestyle. Many six-figure earners are carrying so much debt that they feel like they’re broke everyday. It ís important to limit the amount and especially the type of debt you take on because that will determine your debt-to-income ratio.
Your debt-to-income ratio (DTI ratio), also called your debt-service ratio (DSR) is a number that financial institutions use to determine if you have too much debt. This is calculated by adding up your total debt payments for each month, then dividing it by your total monthly income.
For instance, if you earn $3500 a month and pays total debts of $2000 each month, your DTI ratio is:
1500/3500 * 100 = 43%
The highest DTI ratio a person can have and still be considered for a mortgage without exception is 43%. However, most lenders will consider you to be more creditworthy when your DTI ratio is 36% or less. The sweet spot is a DTI ratio between 18% and 36%.
If your DTI ratio is at 43%, even that could prove difficult for you to get a mortgage because lenders will view you as a high risk customer. This is why there are many high income earners who cannot qualify for a mortgage because, unfortunately, the higher people’s income, the more debt they tend to carry.
Parkinson’s Law says, the more people make the more they will spend because they believe that having more income is the license to live in bigger homes, drive more expensive cars, wear more expensive clothes, go on more expensive vacations and so on.
And while I agree that making more income definitely gives you the means to be able to do more and enjoy a better lifestyle, if having more means taking on more debt then that’s a terrible mistake. The key is to create a balance and try to avoid bad debt at all costs. If you’re taking on debt that is not putting some money in your pocket, putting a roof over your head, driving you to work or your place of business on time, to name a few, then reconsider your decision.
How Do I Manage My Debt-To-Income Ratio?
There are various strategies that can be used to reduce your DTI ratio and the ones you choose will depend on your personal financial circumstances. Here are 5 of the common ones that most people use.
- Control Your Use of Credit Cards
Credit cards are great because they give you no interest grace periods, increase your buying power, cash back and other rewards benefits plus some protections against fraud and unscrupulous sellers, but for some people, using the credit card even once can be the beginning of a personal financial disaster. The key is to pay off the balance in full each month. And if you’re unable to pay, don’t use the card until your balance is zero.
- Monitor Your Credit Score
It ís important to keep tabs on your credit score so you’re aware how financial institutions are viewing your creditworthiness. Use a system like Borrowell and CreditKarma, which are free to sign up for, to keep an eye on your credit score. Some banks even give you your credit score for free, and update it once each month. Plus It doesn’t affect your credit when you do your own credit check so you can pay Equifax or TransUnion (the 2 credit bureaus) to check your score from time to time. However, if you don’t want to pay, you can request your free yearly credit report from each of the credit bureaus.
- Pay off Student Loans ASAP
Student loans can be a great investment in your education and your earning power in the future. However, they can be a significant financial burden and there is a lot to consider regarding student loans. Today, student loans offer many different types of payment plans and you can choose to pay based on your income, or you can pay based on the regular 10-year payment plan to get it paid off. But it is a wise move to pay it off in the quickest time possible from gifts, tax refunds, or other methods, so that you don’t have that burden hanging over you.
- Reduce The Interest Paid On Debts
While financial institutions usually dictate the interest rates on your loans, if you make your payments on time, and never missed a payment, you can call the institution to ask for a better interest rate. Another strategy to reduce the interest you pay is to transfer credit card balances to a line of credit (LOC) because, not only is the interest rate on LOCs much lower, LOCs charge simple interest (interest on principal only) while credit cards charge compound interest (interest on principal plus previous interest).
- Use a Debt Roll-Up Strategy
A debt roll-up (also called a debt snowball) strategy will help you to get out of debt faster than if you pay based on the method that most people use — putting some extra payments here and there. The debt roll-up strategy either makes you pay off the debt with the smallest amount first or the debt with the highest interest rate first. The one you choose will be based on your financial situation and which will get you out of debt the faster.
The truth is, debt causes a tremendous amount of stress and ill-health. You can live most of your life without credit cards, although having some form of credit record will help you get needed loans such as mortgages much easier. Just make a rule for yourself about how much debt you can reasonably take on, and keep your DTI ratio as close to 18% as possible.
Now that you know how to calculate your DTI ratio, go ahead and do so, and utilize the strategies shared to help you to reduce your DTI ratio to the lowest possible number based on your financial situation.