Give Your Debts a Financial Health Check
Your doctor recommends coming in for an annual check-up as a preventative measure to help you stay healthy. Your dentist suggests a biannual cleaning to keep your teeth and gums in tip-top shape. Even your mechanic advises stopping in for regular oil changes and tire rotations to help your car go the extra mile. Routine check-ups can mean a healthier you and a longer-lasting vehicle. Your finances are no different.
Whether you're preparing to buy a house, are interested in investing, or simply need to know where you stand financially, regularly monitoring your income and spending is the first step to understanding your debt.
Comparing your earnings against your spending, also known as a debt-to-income ratio, is one of the most popular approaches for evaluating if you have too much debt. Lenders, for years, have looked at debt-to-income ratios to get a better grasp on a person's current financial picture to determine credit-worthiness.
Understanding the debt-to-income ratio
A debt-to-income ratio is a measure of financial stability calculated by dividing monthly minimum debt payments by monthly gross income. This calculation gives a straightforward depiction of your financial position. Typically, the lower your ratio, the better handle you have on debt.
Gerri Detweiler, author of "The Ultimate Credit Handbook" (ISBN B00005X1K2) and former director of both the Bankcard Holders of America, Salem, Va., a nonprofit consumer credit and advocacy organization, and the National Council of Individual Investors, Washington, D.C., has seen her share of the negative effects bad credit can have on an individual.
Monitoring your income and spending is the first step to understanding your debt
"Surviving credit crises becomes easier when you understand and accept your financial situation," says Detweiler. "Calculating your debt-to-income ratio gives you important information about if you're carrying too much debt for the money you're bringing in. It's easy to justify carrying debt but, at some point, you have to draw the line."
Determining your debt
While different authorities offer slightly different methods to calculate debt-to-income ratios (see our calculator, Detweiler says whatever approach you take, thoroughness is imperative. The following is one example that includes your mortgage/rent payments in the equation:
Collect your most recent credit billing statements for current balances (contact creditors about bills for which you do not receive statements). Some debts, such as credit cards, do not have fixed monthly payments. However, you can estimate the minimum amount by taking 2.5% of the total amount you owe.
On paper, outline your total monthly bills using two columns: bill type (such as, car loan, mortgage/rent payments, and so on) and monthly payment . Do not include bills such as taxes and utilities in this list.
Add up the total amount for all of the monthly payments listed.
Calculate your monthly before-tax income, including any additional income such as child support or interest from investments. If you receive a paycheck every other week, as opposed to twice a month, your monthly gross income is your before-tax income from one paycheck times 2.17.
"Get your debt-to-income ratio as low as possible."
Calculate your monthly debt-to-income ratio by dividing your monthly debt payments by your monthly income. For example, someone with a monthly income of $2,000 who is making monthly payments of $500 on loans and credit cards has a debt-to-income ratio of 25% ($500 / $2,000 = .25 or 25%).
"A few of the common mistakes people make when calculating their ratios are either to not figure in all of their debt or to include debt that isn't actually 'debt'--like utilities," says Detweiler. "Be sure to review your checkbook, bill files, and online bill pay services to include everything necessary."
Rationalizing your ratio
Now that you have calculated your debt-to-income ratio, understanding what it means to you is the next step.
36% or less: This is an ideal debt load to carry for most people. Showing that you can control your spending in relation to your income is what lenders are looking for when evaluating if you are credit-worthy.
37% to 42%: Your debts still may seem manageable, but start paying them down before they begin to spiral out of control. At this level, credit cards still may be easy to obtain, but acquiring loans may be more difficult.
43% to 49%: Your debt ratio is high and financial difficulties may be looming unless you take immediate action.
50% or more: Seek professional help to make plans for drastically reducing your debt before it becomes a real problem.
Lenders' view of your debt-to-income ratio
Many lenders establish whether or not you qualify for a mortgage, a car, or for credit based on your debt-to-income ratio. Lenders want to ensure they'll be paid back for their investment.
Avoid debt reaching a problematic stage.
Most mortgage lenders employ the "33/38 rule" when looking at debt-to-income ratios. This means that in order to qualify for a mortgage, your monthly house payment cannot surpass 33% of your gross monthly income and your total monthly debts (determined above) should not exceed 38%.
If your ratio is heading toward the financial danger zone, it doesn't necessarily mean lenders automatically will deny you a loan. "It's crucial to get your debt-to-income ratio as low as possible and keep it that way," says Detweiler. "However, with mortgage underwriting, for example, other compensating factors such as a hefty down payment or a good payment history can counterbalance. If anything, it may mean you pay more, but that's not even always the case."
Checking up on your debt-to-income ratio
The logical time to figure your debt-to-income ratio is when you're looking to purchase a house or apply for a credit card. However, staying aware of your ratio can help avoid debt reaching a problematic stage.
Detweiler suggests recalculating your debt-to-income ratio on an annual basis or before or after major life events. "It's important to do a financial health check at least once a year," she says. "Yet, it's also important to do when contemplating a job change such as quitting a job or taking a pay cut; getting married or divorced; or making other financial changes."
Published April 14, 2003
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