Debt to Income Ratio

The debt-to-Income (DTI) ratio is a financial measurement used to evaluate an individual’s ability to repay their debts and is a crucial part of your overall financial health. It’s calculated by dividing the total monthly debt payments by the total monthly gross income. The result is expressed as a percentage. Why does this matter?

Why Your Debt-to-Income Ratio Matters

Keeping your DTI ratio at a moderate level signals that you’re a responsible manager of your debt, which can improve your credit score and eligibility for financial products. A general rule of thumb is to keep your overall debt-to-income ratio at or below 43%.

It shows how balanced your spending plan is and assesses your creditworthiness.

A ratio below 43% is seen as a wise target because it’s the maximum debt-to-income ratio at which you’re eligible for a Qualified Mortgage —a type of home loan designed to be stable and borrower-friendly. A DTI ratio of 43% or lower is generally considered ideal for most borrowers. The borrower’s debts, including mortgage payments, credit card payments, car loans, and other debt obligations, should be at most 43% of their monthly pre-tax income. If the DTI ratio is higher than 43%, it may indicate that the borrower is overextended and may have difficulty paying debt obligations.

Keep in mind that the DTI ratio is just one factor that lenders use to evaluate loan applications. Other factors, such as credit score, employment history, and assets, are also considered.

Less Favorability in your Spending Plan and Borrowing Terms

When a significant portion of your income goes towards paying debt, you have less left to save, invest, or spend on things you want and need. Additionally, if you have a high debt-to-income ratio, you will be seen as a riskier borrowing prospect. When lenders approve loans or credit for risky borrowers, they may assign higher interest rates, steeper penalties for missed or late payments, and stricter terms.

A debt-to-income ratio over 43% may prevent you from receiving a qualified mortgage, limiting you to approval for home loans that are more restrictive or expensive.

And although it Is used a lot in qualifying people for mortgages, it can be used to manage money and debt better. As interest rates increase, decreasing and lowering your debt burden becomes more critical.

Different Types of Debt-to-Income Ratios

There are two main types of DTI ratios – front-end ratio and back-end ratio. The Front-end DTI ratio calculates the income percentage used to pay housing expenses, such as mortgage or rent payments. The back-end DTI ratio considers all debt payments, including housing expenses, credit card debt, student loans, and car loans.

Importance of Debt-to-Income Ratio for Loan Approval

A low DTI ratio is a positive sign for lenders, as it may indicate that borrowers have the financial stability to repay their debts. A high DTI ratio can signal to lenders that borrowers may struggle to repay their debts and may be at a higher risk of defaulting on their loans. As a result, lenders may only accept loan applications or offer more favorable terms to borrowers with high DTI ratios.

How do you Calculate the Debt-to-Income Ratio
  1. Add up your monthly debt payments (rent/mortgage, student loans, auto loans, and monthly minimum credit card payments).
  2. Find your gross monthly income (your monthly income before taxes).
  3. Debt-to-income ratio = your monthly debt payments divided by your gross monthly income.

Here’s an example:

You pay $1,900 a monthly for your rent or mortgage, $500 for your car loan, $300 in student loans, and $400 in credit card payments—bringing your total monthly debt to $3100.

Your gross monthly income is $6,500.

Your debt-to-income ratio is 3,100/6,500, or 47%.

A Debt-to-Income Ratio of 36% or Less

A debt-to-income ratio of 36% is considered a good debt-to-income ratio. With a DTI ratio of 36% or less, you have a healthy monthly income to put towards investments or savings. Most lenders will see you as a safe bet to afford monthly payments for a new loan or line of credit.

DTI Ratio and Credit

Credit reporting agencies don’t collect consumers’ wage data, so a debt-to-income ratio won’t appear on your credit report. Credit reporting agencies are more interested in your debt than income history. Although your credit score isn’t directly impacted by your debt-to-income ratio, lenders or credit issuers will likely request your income when you submit an application. Just as your credit score will be one factor in their application review process, your debt-to-income ratio will also be considered. A high DTI ratio can hurt a person’s credit options as it can indicate that they are overextended and may struggle to repay their debts. A low DTI ratio can help improve credit options as it shows that a person is financially responsible and able to manage their debts.

Improving your DTI Ratio

If you have a high DTI ratio, you can take steps to improve it. This can include paying down debt, increasing income, or a combination of both. Reducing monthly debt payments by paying off credit card debt or negotiating lower interest rates can also help improve the DTI ratio.

By regularly monitoring your DTI ratio, you will identify areas where they can reduce debt or increase income to improve their financial stability.

The DTI ratio also provides you with a good snapshot of your current financial health. If it’s below 36%, you’re in a good position to take on new debt and pay it off with regularity. But when it’s over 50%, you should try to reduce the number of debt obligations (by either working to pay off credit cards, find a more affordable home, or refinancing your current loans) or find ways to generate more income. When your DTI falls between 35% and 50%, you’ll usually be eligible for some approvals. Even so, your financing terms on lines of credit will be better if you hit the premium level of sub-35% debt-to-income.

The DTI ratio is useful for individuals to assess their financial situation and determine if they are overburdened with debt. It’s also a valuable tool for lenders to evaluate the creditworthiness of loan applicants and determine the risk of loan default. Maintaining a low DTI ratio can help individuals improve their chances of being approved for a loan and ensure that they are in a better position to repay their debts, and ensure they are on a path to financial security.

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Tips to Manage Your Debt

Managing debt can be challenging, but it is essential to personal finance. With the right approach and some discipline, you can reduce and eventually eliminate debt, helping you achieve financial stability and peace of mind. Below are some tips for manage your debt.

Create a Spending Plan

The first step in managing debt is understanding how much money you have coming in and going out. Create a spending plan that considers all your income sources and expenses, including your monthly debt payments. This will give you a clear picture of your financial situation and help you determine how much money you can realistically allocate to paying off debt.

Additionally, a spending plan will help you to cut your expenses and free up more money for debt repayment. This will mean cutting back on entertainment, dining out, or other discretionary spending or finding more cost-effective ways to meet your needs.

Prioritize Your Debts and Avoid Credit Cards

Once you have a spending plan, it’s time to prioritize your debts based on their interest rates, balances, and payment due dates. Focus on paying off high-interest debt first, as these debts will cost you more over time. Consider using the debt snowball or debt avalanche methods to help you stay motivated and make steady progress. And avoid using credit cards. Credit cards often have high-interest rates and can easily lead to more debt. Try to use cash or a debit card instead, and only use credit cards for emergencies or when you know, you can pay off the balance in full each month.

Pay More Than the Minimum and Pay on Time

Making only the minimum payment on your debts will keep you in debt for longer and cost you more in interest over time. Try to make extra payments whenever possible to pay down your debt faster and reduce the interest you pay.

Paying late can result in additional fees and interest charges, making it even more difficult to get out of debt. Set up automatic payments or reminders to help ensure that you make your debt payments on time each month. A calendar is a great tool to help you record when payments are due and keep you on track.

Consider Consolidating Debt and Negotiating Interest Rates

Debt consolidation may be a good option if you have multiple debts with high-interest rates. This involves taking out a new loan to pay off multiple debts, typically at a lower interest rate. Just be sure to compare the terms and interest rates of different debt consolidation options to find the best choice for your situation. And if you have a good payment history and a high credit score, you may be able to negotiate lower interest rates on your debts. Contact your lenders and see if they are willing to lower your interest rates or offer more favorable terms. The worst they could say is no.

Avoid New Debt and Boost Your Income

While you are working to pay off your existing debt, it makes sense to avoid taking on new debt. This may mean putting off large purchases, using cash instead of credit, or finding ways to save money on everyday expenses.

Additionally, increasing your income can help you pay off your debt faster. Look for ways to earn more money, such as taking on a side job, selling items you no longer need, or renting out a room in your home.

Seek Help and Stay Disciplined

If your debt is overwhelming, consider seeking professional help. There are organizations and agencies that offer debt counseling and financial management services, and they can help you develop a customized debt repayment plan that fits your situation and budget.

I am a financial coach and counselor and would love to work with you to manage your debt. Connect with me here

Paying off and managing debt takes time, discipline, and effort. It’s a process that may take time to see results, but well worth it in the long run. Stick to your plan, avoid slipping back into old habits, and stay focused. By following these tips, you will find the right approach to reduce your debt, improve your credit score, and achieve financial stability.

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5 Tips to Reduce Debt

One of the first steps to managing your finances well is to know where you stand with debt. People use and go into debt for many reasons depending on our financial situation, life needs, and personal preferences. Debt can be classified into four main categories: secured, unsecured, revolving, or mortgaged. Below are 5 tips for reducing debt and paying debt off faster.

Create a Spending Plan Now

If you are using a spending plan already, great! If you are not using a spending plan, start using one today. To manage your finances well, you must know where your money is going, and a spending plan helps you to do that. Recording your transactions is a great habit and understanding your cash inflows and outflows is a great way to uncover new ways to save.

With some planning and managing, you can reduce the stress of borrowing and improve your financial health while reducing debt. Creating and using a spending plan will also help you live within your means and not have to use credit on everyday items like gas and groceries.  

Pay More Than the Minimum

Paying as little as $10 more than the minimum on your debt payment will help pay your debt faster and save you money in interest. For example, if you have a credit card with a $1,000 balance and an 18% interest rate and pay only the minimum monthly payment, it will take almost three years to pay off the balance. The total price would be about $1,304, meaning you are paying out $304 in interest alone.

On the other hand, using the same balance, interest rate, and minimum amount due, let’s say you pay more than the minimum due each month. If you were to pay an additional $60 each month, or a total of $100, it would take just 1 year to pay off the balance, and the interest paid would be reduced to $103, a significant saving.

It makes a big difference to pay more than just the minimum due, in both the time it takes to pay off debt and how much you end up paying. Of course, the optimum plan would be to pay the balance in full each month and avoid paying interest altogether, but the most important thing is to make sure your payments fit your spending plan. 

Make Biweekly Payments

Instead of paying your mortgage once a month, slice your payment down the middle and send half every two weeks. Why? There are 52 weeks a year, so this works out to 26 biweekly payments, meaning you would pay 13 total payments.

Biweekly mortgage payments don’t save you money by lowering your interest rate; they save you on interest by paying your mortgage earlier. When you pay your principal balance down faster, there’s less interest and less debt.

Choose One Debt and Pay it Off

Two approaches to this strategy are snowball or avalanche methods of debt reduction. In the avalanche method, you pick the debt with the highest Annual Percentage Rate (APR), attack it until it’s paid off, then move to the next highest APR. This will reduce the largest chunk of money you’re spending on interest.

With the debt snowball method, you focus efforts on the smallest balance. When your first debt has a zero balance, you take the amount you were paying towards that debt and use it to pay down the next debt on your list, paying off that debt quicker, and so on. Once you move all your debts to a zero balance, you can begin applying all your debt repayment spending plan items toward your savings to help you reach your long-term goals.

Use Savings to Pay Debt

If you owe more in interest on your debt than what you are earning in interest on your savings, you may want to use some savings to reduce your debt.

Paying down high-interest debt with savings may be a better use of your money. While it’s essential to build up your savings for many reasons, such as having money to pay for emergency expenses, there are times when that money may be more helpful in paying off debt. Paying off high-interest debt is one.

Reducing debt is always a good idea, and the 5 tips for reducing debt above can help pay off debt. Using a spending plan, paying more than the minimum, and paying off debts early, will save you interest. And with your debt paid off, you can put more of your money into saving and financial goals. Comment below; I would love to hear from you.

Secured and Unsecured Debt

What is the difference, if any, between secured and unsecured debt? Both are debt, and isn’t debt, debt? What makes unsecured debt different than secured debt? Well, let us take a look and see.

What is Unsecured Debt

Unsecured debt is a finance term that refers to any debt obligation that is not collateralized. Collateral is something of value you own or an asset you put up to secure a loan or debt obligation. With unsecured debts, there is no tangible property or other product attached to that debt.

In the case of unsecured debt, a lender loans money without the security that an underlying asset provides. 

With unsecured debts, lenders don’t have the right to any collateral for the debt. If you fall behind on your payments, they don’t have the right to take any of your assets. However, the lender may take other actions to get you to pay. For example, they will hire a debt collector to collect the debt. If that doesn’t work, the lender may sue you and ask the court to garnish your wages or take an asset. The lender can also put a lien on another of your assets until you’ve paid your debt.

Examples of Unsecured Debt

Typical unsecured debts include credit cards, medical bills, student loans, and store credit cards where you do not have to put up any material as security for the debt.   

Also called signature loans or personal loans, borrowers often use unsecured debt for purchases such as computers, home improvements, or unexpected expenses. 

An unsecured loan means the lender relies on your promise to pay it back and nothing more. For this reason, unsecured debt carries more risk for the lender, making the loan more expensive. The more additional risk a lender must take on, the higher the rate of interest a borrower must pay, making unsecured loans subject to higher interest rates. Additionally, you have set payments over an agreed period, and penalties may apply if you want to repay the loan early. 

What is Secured Debt

In contrast to secured debt, if the creditor can take an item of property away from you to cover the debt, you are working with a secured debt. The creditor will sell the asset if the lender must take your asset because the account becomes delinquent. If the selling price for the asset doesn’t completely cover the debt, the lender may pursue you for the difference.

The fundamental difference between secured and unsecured debts is that tangible items are attached to the debt. Debts such as mortgages and car payments usually have tangible items attached to them, i.e., your house or car. Secured debts are tied to an asset and considered collateral for the debt. Lenders place a lien on the asset, giving them the right to take the asset if you fall behind on your payments. So, for example, your mortgage loan is secured by your home, and auto loan by your vehicle.

In a secured debt situation, as the borrower or person seeking the loan, if you were to file bankruptcy, failed to pay the debt obligation, or failed to meet the terms for repayment, the asset that secured the loan that you put up to cover the loan, would cover the debt.

Debt and Bankruptcy

The big difference between the two types of debts happens or is applicable when someone files for bankruptcy. In Chapter 7 Bankruptcy, you can choose to keep the product or property and pay off the debt in some way. But if it is decided that you cannot pay at all, you also have the option of giving the product or property back and paying off your debt that way. On the other hand, in Chapter 13 Bankruptcy, you are allowed to keep the merchandise or property, but you will be allowed to pay off your debt according to the Chapter 13 plan.

There you have it—the difference between unsecured and secured debt. There is a difference, and it can be a big one. Know what you are getting when you take on debt. Is it secured or unsecured? Comment below. I would love to hear from you.