Your debt-to-income ratio is one of many factors lenders use to evaluate your creditworthiness. The relationship between your total outstanding debt and level of income provides clues as to how likely you are to experience financial distress in the future. Understanding and actively managing this ratio is therefore crucial whether you are running a small business or merely balancing your checkbook.
Your debt-to-income ratio is simply your total debt payments divided by your gross income for a specific period of time. This ratio is most frequently calculated on a monthly basis, though any time frame is just as useful. To calculate your debt-to-income ratio, first add up your gross income -- that's your income before taxes -- from all sources for an average month. Next, add up all of your monthly debt payments, including mortgage, car loans, minimum monthly credit card payments and so on. By dividing the second figure by the first and multiplying the result by 100, you will arrive at your monthly debt-to-income ratio.
Example of a Debt-to-Income Calculation
Assume you get a direct deposit of $2,200 into your checking account every month after your employer withholds federal and local taxes. A closer look at your pay-stub reveals that your monthly gross income is actually $3,400 and $1,200 is withheld for taxes. This means that the income figure you will use is $3,400. Next, a run-through of your monthly statements shows that you make a mortgage payment of $600 every month and have two credit cards with monthly minimum payments of $150 and $190 respectively. Even if you routinely pay more than these minimums, only use the minimum payment obligations in your calculations. Therefore, your total debt payment per month is $600 plus $150 plus $190, which equals $940. Your debt-to-income ratio is $940 divided by $3,400 and multiplied by 100, which equals 28 percent.
A high debt-to-income ratio means you have little slack -- and that even a slight rise in your payment obligations or a small decline in your earnings could result in payment difficulties. If you are spending half of your modest income to make the minimum monthly debt payments, chances are that the remaining half is barely enough to cover such necessities as food, transportation and utilities. Therefore, acquiring additional debt might really push the envelope and as such, lenders might not approve you for an additional credit card. Furthermore, if they do, the rate will likely be very high to make it worthwhile for a financial institution to take the risk.
Managing the Ratio
There is no cutoff for the debt-to-income ratio when it comes to credit card approvals -- and what constitutes an excessive ratio depends on the types of debt you carry. However, a lower ratio is always better. Generally, keeping your debt-to-income ratio below 36 percent is preferred, as this is the threshold that mortgage lenders and credit card issuers often want to see to offer credit at a good rate. You can lower your debt-to-income ratio by reducing your minimum monthly payments. Transferring high interest credit card balances to an account with either lower interest or lower monthly minimum payments -- or both -- will help lower the ratio. Refinancing your mortgage to lower monthly mortgage obligations is also a step in the right direction. Increasing your income will of course improve the ratio, too, but that is usually harder and not possible in the short term.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.