Having debt is rarely just as simple as owing a lender principal and interest. There is always more at play than just the debtor and the creditor, and the situation becomes especially complicated if you have to pay a debt later than when you are supposed to. This is an analysis of how debt affects you, your credit score, and can even change the terms of the debt itself.
What is the Debt to Income Ratio?
This may be a new term for some readers, but it is exactly what it sounds like: all of your monthly debt payments divided by all of your monthly income before taxes. Due to the nature of this calculation, those with higher debt to income ratios are more likely to have more monthly debts, thus more likely to have a hard time paying off those monthly debts.
The higher that your debt to income ratio is, the less likely that a lender is going to consider you for a loan. This especially holds true if you are seeking a big-ticket loan, such as a mortgage. Generally, lenders will accept someone with a debt to income ratio of thirty six percent or less. If your ratio is higher than that, there are ways to fix it: either by adjusting the amount of debt that you acquire each month, or by increasing your monthly income.
Though it is difficult, you can lower your monthly expenditures. If you are looking for ways to lower your debt, you should see if there is a credit card out there with a lower interest rate, or a better cash back program, than your current credit card. If you have multiple debts to multiple lenders, you can also consider taking out an unsecured personal debt consolidation loan. That way, the interest rate is typically much lower, and you only have to worry about paying back one lender instead of doing all the math that multiple debts to multiple lenders requires every single billing cycle.
There are also ways that you can increase your monthly income, which would also help lower your debt to income ratio. You can diversify your stock portfolio with stocks that will slowly but surely gain you profits over time. If you have enough time, you can take on a freelance or part-time job to bring in some extra money and possibly polish some skills for your resume so that you can get an even better, more high-paying full-time job as well.
How Does My Debt to Income Ratio Affect my Credit?
The debt to income ratio does not directly influence your credit score, but it does indirectly influence it by affecting your credit utilization ratio. Your credit utilization ratio refers to the amount of credit that you actually utilize compared to your credit card limit, and it accounts for 30% of your composite FICO score. Unlike with the debt to income ratio, this ratio and credit utilization in general, varies individually and spans across multiple cards, so there is no percentage that will get you in trouble, but in general, you should aim to use no more than 35% of your total credit limit at any time.
Where the debt to income ratio comes into play is rather indirect. Part of your debt is going to be your credit card debt, which means that the higher your debt to income ratio, the higher your credit utilization ratio will be as well. People with wildly high credit utilization ratios are seen as irresponsible with their credit, and thus are given lower credit scores. Both your debt to income ratio and your credit score will help determine whether or not a lender is actually going to lend to you or not. It can be the difference between you being able to purchase the items you want, or taking out a loan to pay the bills during a time when you just need to get by. It is important to keep both ratios low so that lenders have no reason to deny you a loan.
How Does My Debt to Income Ratio Affect my Interest Rate?
When determining whether or not you are eligible for a loan, creditors analyze your debt to income ratio. They not only analyze it to determine whether or not they should lend to you in the first place, but they actually use the ratio to also determine what the interest rate on your loan will be, especially when it comes to mortgage loans. The rule of thumb is that the higher your debt to income ratio, the higher your interest rate on the loan you are going to take out. Likewise, the lower your debt to income ratio is, the lower that the interest rate on your loan will be.
While this may seem unfair, there is logic to this system on the lender’s behalf. Because individuals that have higher debt to income ratios pose higher risks to the lenders, and they may not get their money back from lending to those people. However, they are more likely to get their money back from someone with a lower debt to income ratio, so they don’t have to charge that individual as much. What this means for the person with the high debt to income ratio, though, is that they can be caught in an endless cycle of debt and interest. The higher the interest rates, the more debt they will find themselves in, and the higher their debt to income ratio is.
You should keep your debt to income ratio in check, no more than 35% if possible, because no matter how healthy your credit score is, your debt to income ratio can be the difference between being accepted for a loan or being denied. It can also be the difference between you getting caught in a cycle of debts and interests that you can’t escape, so if you find yourself with a higher debt to income ratio than you would like, then it is in the best interest of your financial future to find a way to either reduce your monthly debts or to increase your monthly income.