Your personal finance is not only about income. It has debt part too. Personal loans, credit card payments, mortgage and other regular obligations are there. These obligations take a certain ratio of your income. The lower is this ratio the stronger are your finances. You have more money in your hand to save, spend or afford a new debt.
Let us understand all the relevant technicalities of debt-to-income ratio. Understand how significant it is in your personal finances.
What is the debt-to-income ratio?
Debt to income ratio is a financial parameter that tells how much of your income goes into paying debts. According to this percentage, you can know how stable your financial condition is. Usually, 36% of debt income is considered an idol.
It means that if up to36% of your overall monthly income is going in paying debts, it is a satisfactory percentage. However, the actual idol ratio is considered to be between 23% to 30%. There is a simple formula to calculate this ratio.
Calculate debt-to-income ratio –
DTI = Total monthly debt payments/ Gross monthly income x 100
Why does it matter a lot?
If you notice, then debt to income ratio plays a very important role in your financial life. It affects your financial decisions on many aspects. Let us know what are the reasons due to which debt to income ratio is so important?
Helps in financial planning
For financial planning, it is important that you know your total income ratio. If you want to arrange money for additional expenses, you should know the debt ratio. This ratio is in comparison to your income.
For example, you want to create an emergency fund. In that case, you should know how much of your income is left in spare after debt payment every month. From that, you have to manage your monthly expenses. After that, you can use the amount that is left to create your emergency fund.
Important for lenders
Whenever you apply for a loan, your debt to income ratio is also an important factor for lenders. Whether you apply for a small loan like a 12 month loan by direct lenders or a big loan like mortgage, your debt to income ratio affects the lender’s decision.
Your debt-to-income ratio is the only way to know your repayment capacity. Just as a loan applicant has a high debt-to-income ratio, he is considered a risky borrower. In such a case, there is a chance of rejection or the loan is approved at a high interest rate.
Therefore, it is said that keep your debt to income ratio in check. The lesser part of your income goes in debt payment, the more are the chances of taking a new loan.
The key indicator for investment decisions
To invest for the future, it is important that you keep a complete account of your debt. If you are planning for early retirement you need smart investment. If you just expect a financially stable future, it is important that your debt is under control.
According to your debt, you get to know how much effort you have to put in for your investment. If your debt consumes a major part of your income, then you will have to pay off the debts early. In simple words, debt to income ratio is your present situation but it is a mirror of your future.
Accordingly, you take your future investment decisions and also do financial planning to improve your personal finances in the current situation.
Helps in making a realistic budget
You can prepare your monthly budget according to the percentage of your debt. According to that, you get to know how to manage your expenses. If your applications come, then you will face difficulty in spending.
In such a situation, you will automatically make a plan to reduce the debts, whether it is through consultation or by paying off the debts. By budgeting according to the debt-income ratio, you are able to do better debt management.
In that situation, you know which short-term loans you have to pay off. Also, you can request your lender to revise the interest and monthly repayment for big loans like mortgages.
How to improve your debt-to-income ratio?
So, you know what changes you can make in your finances if your debt-to-income ratio is higher than the idol ratio level. This is not only profitable but also important for your financial future.
Pay off existing debts faster
If your debt to income ratio is more than 36%, then it is important that you pay off your existing debts. If you have long term debts like mortgage, it is impossible to pay them off immediately. In such a situation, paying off most of the short term debts is a better option.
Example, if you have taken 12 month loans by direct lenders try to pay off these small loans quickly by making part payments. The sooner you pay off high interest debts, the sooner your debt to income ratio will improve. It will also have an impact on your credit rating. Paying off debts improves your credit score.
Consolidate or refinance loans
One of the most popular ways of managing your debts is consolidation or refinance. In debt consolidation, you convert multiple loans into a single loan. The advantage of this is that whereas earlier you were paying in multiple installments, now you pay single installment.
In refinancing, you take the existing loan at a lower interest rate, and the size of your installment is also smaller. However, for refinance, it is important that your repayment history is satisfactory to the relevant lender. You can work on any of the two options according to your financial condition.
Avoid taking new debt
You should avoid taking any kind of new loan. If you are facing problem in managing existing debts then it is also important that you avoid new ones. Your debt to income ratio is already derailed. In such a situation, taking a new loan can make your debt management efforts useless.
It is right to take a new loan only when there is an extreme need. Otherwise, you can fulfil your needs by using your savings or emergency funds. A very popular method is to generate funds by selling out usable and functional things you are not using now. By this, you avoid the burden of new debt, and your debt-to-income ratio improves quickly.
Increase your income
By increasing your income, you can pay off your debt early. This will give you extra income in spare, which will help you manage your monthly expenses. Along with this, your debts will also be paid off early, which will improve your debt-income ratio.
You can generate additional income through any side gain or you can use the extra earnings through promotion or bonus at your workplace to manage the debt.
For some time, avoid all unnecessary expenses and focus on paying off the debt. This will control your debt and also provide you with financial stability.
Conclusion
To live a good financial life, it is important that you keep your debt under control. Whenever your debts dominate your income, your financial stability is affected. Today, people everywhere are getting depressed due to financial stress.
As a result, they are getting other types of health issues. Due to this, their expenses are increasing even more. Therefore, it is most important that you do not let your debt go out of control in any way. Having an ideal debt-income ratio is important not only for your finances but also for your mental and physical health.
