How to Calculate Your Debt-To-Income Ratio Accurately?
Many people find themselves in sticky situations with their finances. Unfortunately, few of us are ever taught how to manage our money. We know we get a paycheck and have bills to pay. We pay the bills and maybe save some money, but that is about it. Few of us have a true understanding of how finances work. As a result, we do not save enough money.
We do not do enough to protect our finances. Let’s face it, many of us are just getting by. It is never too late to gain control over your budget. It all starts with a basic understanding of budget, credit and your debt-to-income ratio. Continue reading to find out all you need to know.
What Is Debt?
I believe in starting at the beginning with the basic information. US News and World Report gives a basic definition of debt as one person owing money to another person or entity. There are many types of debt for varying purposes. I am going to give you a quick run through of different types of debt you will most likely experience in your life.
A mortgage is a loan of a large amount for the sole purpose of purchasing a home. You borrow this money from a bank or mortgage lender. The house you purchase is considered collateral. You and the lender essentially own the house together until you pay off the mortgage and the house becomes yours. If you default on the loan, the lender can take sole ownership of the house. The absolutely will do so. That is what happens in a foreclosure.
A car loan is a loan specifically for the purchase of a car. These loans are a high amount, but no where near as high as a mortgage. The lender, typically a bank or a car manufacturer such as Honda, allows you to borrow the money for the car. Similar to the house, you and the lender are basically co-owners of the car until you pay off the loan. If you default on the loan, the lender can and will repossess the car.
A personal loan is money given to you from a lender with your promise to repay the money. You make monthly payments for the term of the agreed upon repayment schedule. These types of loans can be used for any use. They are typically lower than the amount you borrow for a car loan, but could be as much. These are unsecured loans, which means they do not have collateral attached to them. They are riskier for the lender because there is nothing to guarantee you will pay back the loan. Any one of these types of loans impact your debt-to-income ratio.
How Do I Determine My Debt-To-Income Ratio Correctly?
It is important to accurately calculate your debt-to-income ratio. Your debt-to-income ratio looks at how much money you owe per month versus how much you earn. It is the amount of your gross income per month that is for rent / mortgage, credit cards, and other debt. Your gross income is what you earn before taxes. Most lenders want your debt-to-income ratio to be less than 43 percent of your income.
Here is a simple way to calculate your debt-to-income ratio:
You add up all your monthly bills. Make sure to include all bills. Do not include expenses like groceries, utilities, and taxes.
- Rent or mortgage payment
- Any child support or alimony
- Student loans
- Car loans
- Credit card payments
- All other debts
Divide the total of the amount in step one and divide it by your gross monthly income. Remember that is the amount before taxes.
The number from step two is your debt-to-income ratio. It is a percentage. The lower the percent, the less of a risk you are to lenders.
Is All Debt Bad?
No, not all debt is bad. The truth is we all need some debt in our lives. It helps us build a positive credit history. It helps us get those big purchase items, such as a house, that we would not be able to afford. A good rule of thumb is if debt puts you in a better financial position, it is considered good. If it puts you in a worse financial position, it is considered bad. It is really up to you to use your debt wisely. If you take on debt that you do not really need, it is not good debt.
There is a difference between taking on debt to buy a house or car and debt to buy a new tv. When you have too much debt, it can negatively impact your credit score. Even when you pay all of your bills on time, having too much debt causes your credit score to decrease. Having more debt impacts your debt-to-income ratio.
What Is A Budget?
The most important piece to your finances is your budget. Your budget should control every financial decision you make. I realize that sounds a bit dramatic, but that does not mean it isn’t true. Your budget should be created with your personal goals in mind. While keeping these goals in mind, you also want a budget that allows you to gain and maintain control. The entire purpose of a budget is to understand your incomes and expenses. A budget allows you to see where you are spending money each month. It can also help you determine where you need to make changes.
— Loanry.com | Loan Shop 🏪 (@LoanryStore) July 25, 2019
I am sure you have heard the phrase start with the end in mind. To do this, you have to understand your end. Is your intended end to save money? Are you trying to pay off all of your debts? Perhaps, you want to do both. No matter what your focus is, you should start thinking about a budget with that goal. If you want to pay off your debts, you need to know how much you owe.
If you know that you want to save money, you should know how much you want to save per year. When you know these numbers, you can then begin to create a budget around them. First, you must understand your income and expenses. When you understand those things, you can better understand your debt-to-income ratio.
How Do I Create a Budget?
The best way to create a budget that works for you is to gather all of your data. You need to list out your income and all of your expenses. Your income is usually pretty simple, but your expenses are more complicated. You need to gather your expenses and list them all out. It may take some time to get them all listed, but it is worth it in the end. There are some common expenses that you should keep in mind when creating a budget. Some of them are things like house or rent, car, credit cards, medical bills, and utilities. Keep in mind, your budget is not set in stone. You can adjust it as needed.
Once you have them listed, you can begin to organize them. You need to understand which of your expenses are must have’s, such as mortgage/rent and car payment. Then you need to determine expenses that are important, like groceries and gas. You continue to create categories and put each item into a category. Make sure you create a category that is for optional items such as cable. You can create a category for vacations, or rainy days. You should also create a savings category and one for unexpected expenses.
Now, you must prioritize your expenses. You have begun to do this when you organize your line items. Now is the time when you decide which expenses must be paid first, then second and so on. Once you have done all of this, you add up the total of all your expenses and compare it to your income. You will find yourself in one of three categories. I am willing to bet you knew your category before performing this exercise. You either have extra money every month, you have just enough money to pay all of your expenses, or you have more income than expenses.
What Do I Do If I Have More Expenses Than Income?
So, you have confirmed what you kind of already knew. You are drowning in debt. This mean, of course, that your debt-to-income ratio is well over 43 percent. Now what? Well, you can figure out how to make money, more money, that is. That is a bit of a no brainer, right? If you could do that easily, you probably still would not be reading this. So, how about we talk about some other options.
Remember that budget that you created? Now is the time to go back to it and look at the items that you listed as optional, or the rainy day fund. You are going to have to make some tough choices and begin cutting. Start with the easy items. That gym membership you have that you do not use, cancel it.
If you subscribe to magazines or any other service that you do not use, cancel that, too. Do you go out for coffee each morning? It is time to start making coffee at home. Do you eat out for lunch or dinner often? You can cut that back to once or twice a week, so that it is a special treat and not an every day occurrence.
Once you make those cuts, you need to start looking at the items that are not essential, like cable. How badly do you want those items? Are you willing to give them up for a short time in an effort to get your debt in check? Do you want to improve your debt-to-income ratio. This may be a small price to pay.
Should I Use A Budget App?
I know all that budgeting stuff can be exhausting. We live in a world of modern technology and there are many electronic resources that can help you. There are quite a few money management app available to you. According to Policygenius, many of the apps on the market help you to put your expenses into categories and see your budget change as you spend money. Some of them allow you to take pictures of your receipts to simplify entering your spending. If you are like most people, your phone is always within reach, so you should use it to help your budgeting needs.
Not only can an app help you break your spending down into categories, it makes it easy to search on different expense categories. This makes it simple to see your spending when you need it. This helps you print out a list of expenses whenever you need them. Some apps give you rewards for using the app on a regular basis. If you are interested in using a budget app, you should do research so that you can find the one that best meets your needs. You can even find one that gives you the added perks you want.
What Is My Net Worth?
You may be wondering why I am suggesting that you know your net worth. It is important for you to understand how much you are worth. Your net worth is one of the key pieces to determining your personal wealth. This helps you work towards achieving a debt free and financially independent life. Understanding your net worth also helps you put your debt into perspective. Your personal net worth is the value of your assets minus liabilities. I will talk a little more about your assets in the next section. Net worth is not about income. It encompasses investments, savings, and your debts.
Once you have a better grasp on what you are worth, you can gain perspective on your debt-to-income ratio. Net worth is a balance of assets and liabilities. The two major ways that you can increase your net worth is to increase your assets or decrease your debts. Decreasing your debt seems like a common theme, doesn’t it? Funny, how having a large amount of debt impacts your life in so many ways. This is why is it important to fully understand how debt works. It is just as important to gain control of your debt and your budget.
What Are Assets?
In general, assets are anything that you own. If you are paying a mortgage on your house, you do not own it. It cannot be considered an asset until you actually own it. Any property, even if you are not living in it that you own is considered an asset. When you are considering how much property is worth, consider that real estate prices change often and sometimes quickly.
There are liquid assets, which is any cash to which you can easily gain access, such as cash on your person, or in the bank. Any investments that you have in a retirement account count as an asset. In addition to those investments, any investments that you have in a non retirement account are also assets.
You most likely have personal assets, which are cars, jewelry, or art. You may not want to consider these items as part of your assets because they may not have much in the way of resale value. They may be valuable to you because of their meaning, but they may not be valuable in terms of cash value. If you consider them, keep your estimates low. You may have some other assets not counted in any of the above such as the cash value on a life insurance policy. Be sure that you are using the cash value.
Why Should I Care About My Credit Score?
You should care about your credit score because it is directly impacted by your debt-to-income ratio. If your debt-to-income ratio is too high, it can decrease your credit score. A low credit score puts a damper on anything else that you want to do. Your credit score may seem like it is not that important, but it is a huge deal. A credit score is prominently displayed on your credit report. Your credit report is a detailed listing of all of your debts. It shows your payment history, how much debt you have and how you use it.
Also, it shows the age of your credit. It shows all of your late or missed payments. It even shows loans on which you have defaulted. All of these items listed on your credit report impact your credit score. It is built, or destroyed over time and gives lenders an indication of your credit worthiness. It takes hard work to build your credit score.
Now that you know how easy it is to negatively impact your credit, let’s focus on what is considered bad credit. A typical credit score range from 350 to 850. Most people have a credit score somewhere between 600 to 750. Good credit falls somewhere between 670 to 800. Anything below 570 falls into the danger zone of bad credit. When you have bad credit, it is much harder to get a good interest rate. Lenders feel those with bad credit scores may not be the best candidates to lend money.
How Can Improve My Credit Score?
The bad news is credit can be somewhat fragile. It takes years to build good credit, but just a few missed or late payments have serious implications. If you pay understand how debt and credit work and stay within your budget, you are ahead of the game. You understand more than most people and you are protecting your credit. While it is easy to fall into the bad credit zone, it is hard to get back into the good, or great credit area. It is absolutely possible. It is just hard work.
To improve your credit you need to make all of your payments on time. You must pay the full amount that is expected to improve your debt-to-income ratio. You have to chip away at the amount of debt you owe. None of this happens over night. It takes time and effort, but it is worth it. When you have good or great credit, it opens up so many doors for you. Lenders are willing to loan you money and you do not have to be so picky about where to get a loan.
What Is Debt Consolidation?
I just explained that in an effort to improve your credit score, you need to reduce your debt-to-income ratio. Is debt consolidation they best way for you to go about paying off your debt? First, let me explain what debt consolidation can and cannot do for you. When you consolidate debt, you are taking several smaller debts and combining into one larger debt.
Debt consolidation in and of itself is not going to decrease your debt-to-income ratio. However, by merging several bills into one monthly payment, it allows you to focus on paying down one debt. This can help you budget better because you are focused on one number. You may even have extra money that you can put towards your debt to pay it off sooner.
When you consolidate your debt, you are not getting rid of any debts. You are simply taking out a loan for a larger amount so you can pay off the smaller loans at one time. Most of us feel that one payment is easier to manage and mentally, it puts us in a better position. We feel as though we have made a significant change to our situation. In reality, we have not changed the amount of debt we have. We have only changed the number of payments we make. Sometimes, this is enough to help us regain control and feel like we are moving in a positive direction. Do not discount the benefits to combining all debts into one.
Is Debt Consolidation Right For Me?
You are the only one that can truly answer this question. I can give you some points to consider when making this decision, but I do not have the magic answer for everyone. Often, a debt consolidation loan may come with a higher interest payment. This may be a small price for you to pay to gain much needed control.
If your ultimate goal is to reduce debt and decrease your debt-to-income ratio, this may be the best way. You should create a budget and know how much you can afford to pay each month. If your dent consolidation amount keep you under what you can afford, then this may be the way to go.
One of the deciding factors for you should be can you keep yourself out of debt. When you consolidate your debt, you are not decreasing the amount you owe. You are just making one larger payment. You still have your credit cards, but they no longer have a balance, so you have all of your credit available.
So, you can’t just go on a spending spree, or you will be in worse shape. You must understand that you are working off the same amount of debt and how easily you can be back in a bad place. If you know that you cannot trust yourself not to rack up more credit card debt, you may want to get rid of them.
I have given you a lot of information about understanding your debt and your debt-to-income ratio. I have told you how you can calculate it and have explained how you can reduce it. The bottom line is it is up to you to use debt properly. Debt is not always bad. It is something we need to have and use. Like everything, it needs to be used in moderation.
Debt is a great way to buy a house or a car. It is not the best way to get a new tv. It is great to have a credit card on hand for emergencies, but also easy for spending to get out of control. When it comes to your credit and debt, you are the only one responsible for what happens. You must take control of your spending before it ends up controlling you. Once you allow it to get out of control, it is hard to regain control.
Julia Peoples is a long-time business manager focused on providing decision making assistance to the public. She works with people at key points of their lives who are making important retirement and financial decisions. She has had many articles published that educate the public on sound financial decision making.
Julia writes for those who are working towards financial freedom or a better understanding of how finances work. She has shared her financial insights with individuals on a one on one basis for years.