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 Ratio
The debt to income 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 Minimum credit card payments Student loans Association or condo dues Insurance Child support payments Any other monthly debt obligations 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 Child support received Social security payments Side gigs Trust fund distributions Any other income |
| Calculation | Get out your calculator and divide: Total Debt ÷ Total Income = DTI RATIO 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 300 Line of credit 225 Minimum credit card payments 450 Car payment 225 School tuition $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 debt to income ratio of less than 36 percent is considered good. Anything over 43 percent is too high to qualify for credit. Fifty percent is troubling, according to most experts.
Jack has a debt to income ratio of 42 percent, precariously close to the 43 percent 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. At the end of 2020, for every $1 of disposable household income, Canadians owed $1.71. In real terms, this means that on a household income of $50,000, the average accumulated debt is $85,500. Really.
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 takes home approximately $4,492, and his wife receives approximately $730 in Canada Child Benefit. It may seem like a lot until you consider that it costs the average family of four around $5,548 a month to live in Calgary. This leaves the monthly budget very tight every month for Jack and his family.
When faced with the unexpected, 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 remaining income. This includes, for example:
- Food
- Clothing
- Fuel
- Car repairs
- Entertainment
- School expenses
- Vacations
- Savings, and
- Retirement contributions
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. Still, the past may be a good predictor of what can happen in the future.
For example, what happens if your car needs a new transmission? Or the dog has to go to the vet? Armed with this information, you will have a clearer picture of whether your debt to income ratio is realistic.
How to Fix It
What can you do if the debt to income ratio is too large for comfort? The easiest solution is to make more money. 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.
Or, 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.
Also, look for money in your budget that could go toward your emergency fund. Can you give up your daily coffee to contribute $20 a week to a savings account? You will be less likely to pull out your credit card once you have a cushion.
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 you continue to struggle with getting your debt under control, set up a free consultation with a Licensed Insolvency Trustee to explore your options to get back on track.
