(3 votes, average: 3.33 out of 5)
Loading ...To figure your debt/income ratio, gather your most recent credit billing statements. If you don’t receive a monthly statement for some bills—your car loan, for example—call the creditor for your current balance. This is very important. Your rough idea of your balance may be completely different from what you actually owe.
Debt/Income Ratios
Now, list all your bills in one column. In a second column, list your monthly payments. In a third column, list the total amount you still owe on those bills. (Be sure to list your current outstanding balance, not the original amount of the loan.) Don’t include your utilities or taxes as debts here.
Revolving debts, such as credit cards, do not have fixed monthly payments. You may want to find out from your card issuer how your monthly payments are calculated. Otherwise, estimate that your monthly payments are 2.5 percent of the total amount you owe. (To figure the monthly payment on that basis, multiply the total due by .025.)
Next, determine your monthly income. Start with your annual gross income (income before taxes). Add any additional, steady income you receive, such as alimony, Social Security benefits, or interest from investments. Do not include overtime or bonuses unless they are guaranteed. If you earn an hourly wage instead of a salary, take an average weekly paycheck and multiply that figure by fifty-two (weeks) to determine your gross annual income. You can then divide that figure by twelve to determine your monthly income.
Next, divide your monthly debt payments by your total monthly income. The answer is your monthly debt/income ratio.
The number you end up with will be a fraction. Debt/income ratios are expressed as percentages, so move the decimal point on the number over two places to the right. Here’s an example:
MONTHLY DEBT/INCOME RATIO
400-1500= 26 or 26%
Monthly debt payments - monthly income = debt/income ratio
What Does It Mean? Here’s what your debt ratio means. (I am assuming here that you included a mortgage payment. If you don’t have a mortgage payment, then these numbers should include your rent or the monthly payment you expect to pay, including taxes and insurance, if you buy. If you don’t pay rent or have a mortgage, but you are falling into these categories, then you can assume your debt level is high.)
36 Percent or Less:
37 Percent to 42 Percent:
43 Percent or More:
50 Percent or More:
Most mortgage lenders, by the way, follow the “28/36 percent” rule when evaluating debt/income ratios. That is, to qualify for the mortgage, your monthly house payment debt (including taxes and insurance) should not exceed 28 percent of your gross income. Your total monthly debt payments—housing plus all other revolving and unsecured debts—should not exceed 36 percent of your gross monthly income. (Notice that only leaves 8 percent for nonmortgage debts.) FHA and VA loans and some first-time-buyer programs are more lenient, with acceptable ratios as high as 41 percent. If you can’t meet those debt ratios, you may be required to put up a higher down payment, take out an unconventional mortgage (such as owner financing), or pay some of your debts before you can qualify for the loan.
Current RatioThe main problem with the debt/income ratio method is that it can provide a false sense of security. Since many credit cards require only a very low minimum monthly payment, it may appear that you can afford the monthly payments even though your total debt is unmanageably high, and would take forever to pay off. That’s why figuring your current ratio is important. It will give you an estimate of your overall net worth; how much you have accumulated compared to how much you owe. This ratio is also sometimes called a “liability/asset” ratio or “debt/equity” ratio.
Liabilities are what you owe. When you figured your debt ratio above, you listed your liabilities, so that work should be done.
Assets are what you own. They can include cash; money in your savings, checking, or other bank account; securities such as stocks and bonds; real estate; valuable jewelry, furs, or art; automobiles; cash value of life insurance policies; and pension benefits.
For each asset, determine the current market value of the goods. For example, if you list your car as an asset, check the blue book value to determine how much it is currently worth. If you are having difficulty determining how much something is worth, your insurance company may be able to help you, or you can check ebay.com or the classified section of your newspaper to get an idea of how much similar merchandise is selling for.
To determine your current ratio, divide your total liabilities by your total assets. To express that number as a percentage, move the decimal two places to the right.
If your current ratio is:
30 Percent or Less:
31 to 50 Percent:
51 to 75 Percent:
76 Percent or More:
Make an appointment with a credit or financial counselor for help.
Take a good, hard look at what you can do to increase your assets and decrease your debt. First reduce unsecured debt with high interest rates, then make sure you have an emergency savings account equal to your living expenses for three to six months.
Most financial advisors would consider a current ratio in this range stable, although as you get closer to 50 percent, it’s more questionable. You may benefit from reducing your debts. It is especially important to pay off debts you have incurred on depreciating assets—like car loans or credit card spending for everyday expenses. Think of it this way: You may be able to manage your monthly payments, but over the long term you are giving your lenders a lot of money (in interest) that could be working for you, instead of for someone else.
Your long-term debt position is healthy. You may want to make an appointment with a financial planner or accountant to explore investment opportunities and to make sure you are maximizing tax deductions.
Plan a strategy for reducing your debt before it gets too far out of hand.
You may be keeping up with the bills, but your debt ratio is definitely on the high side. Financial difficulties are probably right around the corner if you don’t start taking action.
You will probably find it easy to get credit cards, but it may be more difficult for you to get other types of loans. If you want a mortgage, you may still qualify for a VA or FHA loan, but some lenders will expect you to pay a higher rate or reduce some of your debt first. It would be a good idea to pare down your debt now, while it is manageable.
A debt ratio of 36 percent or less is generally considered healthy. You would not have trouble getting a mortgage with that debt ratio (provided you qualified on income and credit history, of course). The higher your debt ratio, the more risky your situation.