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You’ve got your number. Your credit score, that is. Why do you need to know how to find your debt to income ratio? Well, in addition to your credit score, lenders use this number to determine how likely it is that you will be able to pay back the money you owe.
The better your debt to income ratio, the more favorable your loan terms will be. Rather than a 22 percent interest rate, you may be offered 9 percent, for example, which can potentially save you hundreds of dollars a year in fees. But, you can use it, too, to understand your financial wellbeing, as well as your ability to thrive during financial adversity.
A ratio is simply the relationship between two numbers. Since most of us forgot ratios after the 6th grade math test, it’s a bit easier to talk about percentages. Lenders typically use gross income numbers and refer to percentages.
Here’s how to find your debt to income ratio in three easy steps.
Find Your Debt to Income (DTI) Ratio
The DTI ratio is an easy calculation to do. It’s a good idea to check yours from time to time. Here’s how:
| Debt | Add your total debt payments. Include every fixed payment you make on a monthly basis, such as: Mortgage or rent Note that although expenses such as rent are not actual debt, you don’t have the choice not to pay it. |
| Income | Add all of your sources of income, such as: Wages |
| Calculation | Get out your calculator and divide: Turn the number above into a user-friendly percentage by multiplying: .by 100. |
Jack’s Numbers
Let’s run through this calculation using Jack, a construction worker. Jack is married, and his wife is a stay-at-home mom. They have two school-age children, and the youngest attends a private school. They bought their home a few years back and have a reasonable mortgage payment, but they also have quite a few bills that never seem to get paid off.
Jack’s debt to income ratio is calculated as follows:
| Debt | $1,300 Mortgage $2,500 Total Debt |
| Income | $72,000 salary / 12 = $6,000 monthly income |
| Calculation | $2,500 / $6,000 = .42 × 100 = 42% |
Recommended Debt to Income Ratio
A DTI ratio of less than 35% is considered good. Anything over 43% is too high to qualify for credit.
50% is troubling, according to most experts, as it takes up more of your income leaving little flexibility in your finances. If you have a high DTI, you may want to make changes or seek advice.
A high Debt to Income ratio can negatively impact your credit score. According to Equifax, about 30% of your credit score is determined by how much of your available credit you are using. Also, a high DTI makes it harder for lenders to trust you if they believe you are not managing debt responsibly, making it harder to get loans.
In the above example – Jack has a debt to income ratio of 42%, precariously close to the 43% cut-off point for further credit. However, he has a decent credit score and usually pays his bills on time. He could probably qualify for another small credit card since he sometimes works overtime and his income fluctuates.
In fact, he is thinking of applying for another card because his existing credit isn’t quite enough. It seems that the moment he pays them down to a manageable level, he is hit with yet another unexpected expense.
Jack isn’t the only one struggling to keep a handle on debt. A high DTI can throw off your budgeting leaving no room for savings or unexpected costs.
Why Your Debt Level May Be Too High
As mentioned, the debt to income ratio is a pre-tax figure. After taxes are deducted. Jack, like many Canadians, has insufficient savings. He will be forced to rely on credit. Unfortunately, his current cards are tapped. When Jack acquires another card to tide the family over between paycheques, it’s easy to see where the trouble begins.
Apply Stress to Test Your Ratio
It’s a good idea to give your budget a stress test. Then, you can decide if your debt to income ratio is okay. Technically, a stress test is conducted by financial gurus to gauge the effect of an economic crisis. You can conduct a personal stress test to determine whether or not the debt you are carrying is appropriate for your household and your budget.
After all of the monthly obligations are subtracted from the total income, you have disposable income remaining. All other household expenses must come from this remaining income.
This includes, for example:
Food, clothing, fuel, car repairs, entertainment, school expenses, vacation savings, and retirement contributions.
You need to factor any of these ‘extras’ in when reviewing your debt to income ratio. If you don’t have a reasonable budget, you may want to create one so that you have a better idea of where your money is going.
But before you subtract out the taxes, increase the amount you pay your creditors so that you are making more than the interest payment on your debt. Now, make the estimated tax adjustment to get a more realistic disposable income number.
Next, if you do not have rainy day savings of at least $1,000, consider your last few emergencies. You can’t really anticipate the unexpected. However, the past may be a good predictor of what can happen in the future and these unexpected costs can pop up when you least expect them.
If You Have a High DTI
What can you do if the debt to income ratio is too large for comfort? Reducing your DTI ratio requires focus, and a plan to manage your debt effectively. The easiest solution is to make more money. Bur since that’s not always a possibility, you will need to work on reducing your debt. This can be accomplished by cutting your discretionary spending so that you can pay more aggressively each month.
- If you do not already have a budget – Create one. It should outline your income, expenses and debt obligations.
- Prioritize high interest debts and pay those off first. – Credit cards is a great way to start since their interest rates are often very high.
- If you have a way to increase your income, do so. These days, we are overworked as it is, and not everyone has this option, but it does make a difference if you can find gig work, PT work, etc. to supplement other income.
If you have several credit cards and loans, you can consider a debt consolidation plan. In Jack’s case, a debt reduction of $200 a month would put his debt to income ratio at a more comfortable 38 percent.
A Good Start
It’s within your power to change your financial numbers. Now that you know how to find your debt to income ratio, you can keep it in line with your financial goals. If your DTI is already 43% and growing, you should consider speaking to a Licensed Insolvency Trustee. Call for a free consultation to explore your options to get back on track.
