Most people have sat around and wondered, “Do I have too much debt?” While there’s no hard-and-fast rule about evaluating debt-in part because it depends on what types-they can keep them self in check by tracking their debt-to-income ratio over time.
To evaluate debt realistically, an individual needs context. Right off the bat, it’s easy to assume $1,000 in debt is better than $10,000-but that’s not necessarily true. More debt isn’t always worse; it depends on the financial situation of the person carrying it. And one major component of any consumer’s overall financial health is their income level.
Comparing how much is being spent each month on debt payments stacked up against a person’s monthly income will help them come up with a simple percentage. Then they can know for sure, at a glance, the proportion of their pre-tax paycheck devoted to debt.
What’s a good debt-to-income ratio? Keep reading to learn about how to calculate the ratio and for what range that a person should aim for to maintain financial health.
Calculating The Debt-to-Income Ratio
The Consumer Financial Protection Bureau breaks down how to calculate a debt-to-income ratio: Start by adding up all monthly debt payments, then divide this number by gross monthly income.
Be sure to consider all various sources of debt, from mortgage and auto loan payments to credit card bills and student loans. And be sure to use gross income rather than take-home pay.
Someone paying $2,000 per month toward debt with a gross monthly income of $6,000 would have a debt-to-income ratio of 33 percent. One-third of this person’s income is going toward debt each month.
Why a High Debt-to-Income Ratio Is a Red Flag
The higher a person’s debt-to-income ratio is, the redder their flag in terms of risk. Lenders often look at this percentage when they’re deciding whether to offer them a line of credit or loan.
According to NerdWallet, a debt-to-income ratio under 20 percent is considered low. One exceeding 40 percent is “a sign of financial stress.” To get a qualified mortgage, a person’s debt-to-income ratio must be 43 percent or lower.
Consumers can use their DTI to figure out how to best tackle their debt, too. If an individual falls around 15 percent or lower, they can probably use DIY methods like “snowballing” or “avalanching” combined with budgeting to methodically eliminate their debt over time.
If a person’s DTI’s a little higher, say 15 to 40 percent, they may benefit from working with a credit counselor to get their ducks in a row, so to speak. While they’re still short of the danger zone, options like debt management and debt consolidation can help them get a handle on unstructured debt before their percentage climbs any higher.
A DTI exceeding 40 percent calls for more heavy-duty debt relief-like settlement or bankruptcy. Debt settlement is a viable option for some consumers facing over $10,000 in debt who don’t qualify for bankruptcy or don’t want to file for it yet. A number of consumers have expressed in Freedom Debt Relief reviews that they chose settlement as an alternative to bankruptcy and found it “far better” and similar sentiments.
Bankruptcy is the most extreme of all debt relief options. While it can provide a fresh financial start for people, this clean slate always comes at a price. Filing for bankruptcy may relieve a person of crippling debt, but it can remain on their credit report for seven to 10 years. However, there’s always the possibility for determined consumers to rebuild their credit and financial standing in the aftermath.
An individual knowing their debt-to-income ratio will help them keep an eye on what they owe vs. what they earn. Maintaining a healthy DTI will help them qualify for the credit they want should they ever want to take on a mortgage or take out a loan.