A good measure to determine if your debt is getting out of control is determining what your debt-to-income (DTI) ratio is. If your DTI ratio is close to or higher than 36% then you should be working to reduce it. Lenders use DTI to determine if a potential customer can afford to take on extra debt. The preferred maximum DTI varies among lenders, however, 36% is often used as the maximum.
So how do you determine your debt-to-income ratio? You first have to determine what your monthly payments are to service your debt. For example, let’s assume your monthly debt is as follows:
Car loan = $300
Mortgage = $1,100
Credit cards = $500
Other debts = $400
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Total debts = $2,300
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Now let’s assume you earn $60,000 per year, which equates to $5,000 per month. You debt-to-income ratio is $2,300 divided by $5,500 which equals 0.46 or 46%. This is very high and a person in this situation needs to take quick action to reduce their debt.
So what can you do to reduce your DTI ratio? You can take the following steps:
Increase your monthly payments to service your debts. Applying extra payments to the principle will lower your overall debt faster.
Stop taking on additional debt. The more debt you take on, the higher your DTI ratio.
Delay large purchases until you have more savings. The larger your down payment, the lower your monthly cost, thus decreasing your DTI ratio.
Calculate your DTI ratio monthly to determine if you are making progress.
Earn extra income by finding a new job or additional work (part time) to pay down your debt faster.
Keeping your DTI ratio at a manageable level is one of the foundations of good financial health. A manageable DTI ratio also gives you peace of mind that you can handle your financial responsibilities and will help you qualify for credit to purchase things your really want like a new home.
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