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Debt-to-Income Ratio

As you start becoming more intentional about your credit score, you will find certain terms coming up. Terms such as available credit, credit types, and even your debt-to-income ratio.

In some ways these terms can be self-explanatory. In other ways, not so much. Today I will be focusing on what the debt-to-income really is and how you can affect it.

First I will admit my own misconception about this term. I thought it was the overall ratio of your total debt to your total yearly income. Say you have $25,000 in total debt, but make $50,000 per year in income, your total debt-to-income ratio would be 50%. This is close, but not quite the true, accepted calculation.

To truly calculate your debt-to-income ratio, you must first add up all of your monthly debt payments. Next, divide that number by your gross monthly income. That is, the income you are paid before taxes, insurance withholdings, retirement savings, and other deductions are taken out. So, you take your monthly credit card payments, add in your car payment, your mortgage payment, student loan payment, and anything else you currently pay off. Divide this number by your gross monthly income. You can either find this value on a pay stub or salary statement or you can roughly guess by taking your gross yearly income and dividing by 12.

As a quick example, say you have the following debt payments with a gross monthly income of say $4000:

$500 - credit card payment.

$350 - car payment.

$110 - student loan payment

$1500 - mortgage

We calculate the debt-to-income ratio thusly:

($500 + $350 + $110 + $1500) / $4000 = 61.5%

This number is rather high. It shows that any further debt is more risky because it eats more into what you need to survive. Thus, your credit score can take a hit if this value is too large.

Your ratio can be affected by incurring new debt on new credit cards, thus adding a new payment and raising your debt-to-income ratio. Increasing your current payments can also raise your ratio. If you find your credit score moving lower and lower when you borrow more, this could be a reason why.

The good news is you can affect this value the other way also. By accelerating debt pay off, you can remove some of these values from the calculation altogether. When you do that it reduces your overall debt-to-income ratio and can help raise your score since you seem to have more "room" to responsibly borrow more money. You can even take it down to a 0% ratio (which means you have no debt payments whatsoever, my personal favorite ratio!)

I encourage you to find your own debt-to-income ratio. Is it higher than you thought? Lower? Where would you like it to be?

I encourage you to think on these things this week and as we move into 2022. Who knows what next year has in store for you with a little more intentionality.

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