A good income to debt ratio will help you tremendously in just about all aspects of your financial life. You’ll qualify for credit more easily because you’ll have a enviable credit score, and you’ll pay a lot less when you borrow money. You’ll also be a more desirable job applicant if you apply for a new job or embark on a new career. That being the case, the question is, how can you have a good income-to-debt ratio? Before we tackle that, let’s cover the basics.
What is an income-to-debt ratio?
It’s a number that compares how much income you have compared to your debt. Most financial institutions turn this around and call it a debt-to-income ratio, but the concept is the same.
That ratio tells lenders how much of your income goes toward paying your debts and housing expense. When more money goes toward these expenses, that means you’ll have less available should something go wrong. For example, if you have a high debt-to-income ratio and you lose your job, you may not be able to pay your debts. That’s because you are already living and spending almost everything that’s coming in. In that case, you may not have a lot of wiggle room if a problem comes up.
Bottom line: People who use a higher percentage of their income to pay debt are considered a higher risk.
This is pretty easy to do. Let’s take a very simple example. Add up all your monthly housing and debt payments. For example, let’s say your monthly housing and debt payments are $1,000. Now let’s compare that number to your monthly gross income. For our example, we’ll assume your gross income is $3,000. To calculate your debt-to-income ratio, here’s what it looks like:
$1,000/$3,000 = 33%
So in this example, your debt-to-income ratio is 33%.
Use the calculator above to determine your own debt-to-income ratio. Double-click on each of the numbers and input your own values. As you do, the debt-to-income ratio will update itself. Don’t update the numbers in “Total Debt Payments” or “Total Annual Income.” Those will also update automatically.
How is your debt-to-income ratio used?
Lenders use your debt-to-income ratio to decide if they want to lend money to you or not. The debt-to-income ratio comes in two flavors, actually. The first is known as the front-end ratio. This is your housing cost-to-income ratio. (If you rent, it’s simply your rent payment compared to your gross income. If you are a homeowner, the top number includes your mortgage payment, insurance, property tax and homeowner’s fees. The lower number is still your gross income.)
The second “flavor” is the back-end ratio. It includes the housing expense you calculated above, but it also includes other debt payments you must make such as credit cards, auto loans, student loans, tax debts, etc.
What does your debt-to-income ratio mean?
If you have a back-end score of 36% or less, you have nothing worry about. You are exactly the kind of person banks want to loan money to. You are a very responsible person and probably have a very good credit score too. Congratulations.
If your score is above 36% but below 42%, you’ll find it more difficult to get loans, which is a shame. Your financial situation is likely pretty good. You can take a few steps (outlined below) to improve your ratio fast.
If your ratio is below 43%, you would be smart to take immediate and decisive action. You may not be in financial trouble yet, but you might be only one paycheck away from financial disaster. It’s time to get serious.
How to Improve Your Income-to-Debt Ratio in 90 Days
Now that you know what your debt-to-income ratio means and how to calculate it, it’s time to roll up your sleeves and get to work.
It’s probably very obvious to you that you have three choices if you want to have a better debt-to-income ratio:
- Make more money
- Decrease debt or cost of debt
- A combination of the two
As I see it, there are 4 ways to increase your income:
Ask for a raise.
Work more hours.
Change jobs or career.
Get a side business going and start being self-employed.
You probably have more than one of the above options available. And sometimes, these are interconnected. Why not ask for more money at work and work more hours at the same time. In fact, you may be able to justify asking for a raise simply by volunteering to work more hours and demonstrating your loyalty and work ethic. At the same time, why not look into launching a side business or get a part-time weekend job? Yes, I’m talking about working a lot harder than before, but it will be worth it to you.
Decrease Debt or Cost of Debt
When is the last time you looked into reducing your cost of debt? Of course if you have a high debt-to-income ratio, you will find it difficult to refinance your debts conventionally. But there are a number of ways you can borrow money inexpensively and reduce your interest expense if you are willing to think outside the box.
Let’s assume you owe $5,000 in credit card. You might go to your family and give them the opportunity to “invest” in you. Go to them with a plan. Show them how you will pay them back and over what time period. Make sure you stick to your plan and let them know that you mean business.
Rather than pay the credit card company 15%, pay your family 6%. They will be delighted to earn that much interest. You’ll save a fortune and they will make much more on their investment with you than they would in the bank. Also, because you reduce your cost of money, your debt-to-income ratio will improve overnight.
If borrowing money from your family isn’t viable, consider a peer-to-peer lender like Lending Club. This company puts people who have money and want to make personal loans together with people like you who need to borrow money.
In reality, the best way to boost your debt-to-income ratio is to do a combination of the above ideas. Do whatever is feasible to boost your income and reduce your cost of debt. Small changes in both numbers will have a huge impact on your ratios, and that in turn will help you qualify for lower cost loans in the not-too-distant future.
When is the last time you calculated your debt-to-income ratio? How did you use it? What did you do to improve it? What impact did that have?
Extremely important topic. I am curious. Is there an ideal level of income-to-debt-ratio to have?
Neal Frankle, CFP ® says
I think this depends on what your goal is. If you want to think about this from someone who is about to advance you credit, probably the lower the better. If you want to think about it from an investment standpoint, if you borrow to invest and know what you are doing, it’s certainly smart to take on debt. However, the answer I think would depend on how stable your income is and what your goals are. Are you currently thinking about taking a big loan?
Neal Frankle, CFP ® says
I’m not sure. And even if there is one……..the question is, what do you do with that information? My policy is to never borrow unless I get to the last resort. That being the case, if I take I loan, I have no choice so I don’t really concern myself with the ratio. I hope that helps.