When it comes to finances, “income” is seen as good while “debt” is seen as inherently bad. Having too much debt and not enough income can indeed leave you in an unstable situation. You may find yourself struggling financially. Not only that, but significant debt can also take a toll on your mental health and wellbeing.
Having absolutely no debt, however, does have some drawbacks. Believe it or not, having no debt gives the impression that you have a short credit history (or no credit history at all). It’s harder to prove that you are a responsible borrower to potential lenders, which makes it harder to qualify for credit cards and loans. If you do qualify, your rates are likely to be higher.
So, if too much debt is bad, but having no debt is too, where is the middle ground? Here’s what you need to know about debt-to-income ratios and what you can do to improve yours.
What Is a Debt-To-Income Ratio?
Your debt-to-income ratio is the total of all your monthly debt payments divided by your gross monthly income. Common debts include:
- Mortgage or rent
- Auto loans
- Student loans
- Personal loans
- Credit cards
Let’s say you have a mortgage payment of $1,200, credit card payments of $300, and an auto loan payment of $150. This leaves you with a monthly debt obligation of $1,650. A monthly gross income of $5,500 leaves you with a debt-to-income ratio of $1,650 divided by $5,500, which comes out to 30%.
Why Your Debt-To-Income Ratio Matters
Your debt-to-income ratio matters for many reasons. For you, the percentage can provide some insight into your financial situation. If your debt-to-income ratio is too high, having to allocate some of your income to a new payment can leave you in a precarious position. You may struggle to keep up with all of your payments, unlike someone who has a lower ratio.
Your debt-to-income ratio also matters to potential lenders and creditors. It lets them know how much of a financial risk you are. People with higher debt-to-income ratios are considered to be riskier, as they’re more likely to struggle with payments or default. If you have a high ratio, applications for credit cards and loans are more likely to be denied. If you are approved, there’s a good chance that your interest rates are going to be on the higher end of the creditor’s or lender’s range.
Does Your Debt-To-Income Ratio Affect Your Credit Score?
Your income doesn’t appear on your credit report, and it’s not a factor in credit scoring. As a result, your debt-to-income ratio doesn’t directly impact your credit scores or reports.
While your debt-to-income ratio doesn’t directly affect your credit score, the total amount of debt that you have does. Your credit utilization ratio compares the total of your revolving debts to your total available credit. These ratios are very important in determining your scores.
The following factors can all significantly affect your credit score:
- Your total debts
- How old your revolving debts are
- Your credit mix (credit cards, loans, etc.)
- Your payment history
- The number of hard inquiries on your credit report
What’s a Good Debt-To-Income Ratio?
When it comes to applying for a loan or new credit card, your debt-to-income ratio plays a role in determining your eligibility. The lower your ratio, the better. While all lenders set different requirements, a generally accepted ratio is 43% or less.
The following is a generalized breakdown of ratios and what they mean to lenders:
- 35% or less: Your debt is at a manageable level and you’re likely to be seen as a good lending risk
- 36% to 49%: While you may be approved for a loan, you should consider lowering your debt. You may need to provide additional proof that you can afford the loan
- 50% or higher: You are more of a lending risk, which means you may not be approved for a loan
If you do have a debt-to-income ratio of over 50%, that doesn’t mean you can’t get a loan. There are still options available. Still, lowering your debt-to-credit ratio is a good idea.
A good debt-to-credit ratio isn’t just important for lenders. It’s also important for you. If you have a high debt-to-credit ratio, you may be struggling to make ends meet. If you need to take on additional expenses, such as unexpected medical bills, you may have trouble managing all of your payments.
On the other hand, a lower debt-to-income ratio provides you with more wiggle room. If you need to take on additional expenses, you can do so more easily without a significant impact on the rest of your finances.
Ways to Reduce Your Debt-To-Income Ratio
Reduce Monthly Expenses
It might not be fun, but cutting back on non-essentials for a while can help to boost your long-term financial success. Creating a budget can help you to see exactly where your money goes each month and show you where you can cut back.
Tackle Debts More Aggressively
Rather than making only the minimum payments on all of your monthly debts, consider attacking your debts more aggressively. A few strategies to consider trying to include the snowball and avalanche methods.
Consolidate Your Debts
Consolidating your debts involves taking multiple debts with varying interest rates and combining them into a single payment with a single interest rate. In many cases, you can lower your interest rate, which saves you money, while you decrease your debt-to-income ratio.
Turn To Your Home’s Equity
If you own your home, you may be able to lower your debt-to-income ratio by tapping into its equity. However, not everyone can get (or wants) a home equity loan. Instead of selling your home and downsizing, what if you could sell and stay?
A sale-leaseback program allows you to sell your home and remain in place as a tenant. The funds you receive for selling your home can be used to lower your debt-to-credit ratio. When you’ve tackled your debts, you can choose to buy back your house if you want. You can also choose to sell and move or repurchase the home later.
Too much debt as a homeowner can be incredibly stressful. Talking to a financial advisor about your options can help you figure out your next steps.