Give Your Debts a Financial Health Check
Your doctor recommends coming in for an annual check-up as a preventative measure to help you stay healthy. Your dentist suggests a biannual cleaning to keep your teeth and gums in tip-top shape. Even your mechanic advises stopping in for regular oil changes and tire rotations to help your car go the extra mile. Routine check-ups can mean a healthier you and a longer-lasting vehicle. Your finances are no different.
Whether you're preparing to buy a house, are interested in investing, or simply need to know where you stand financially, regularly monitoring your income and spending is the first step to understanding your debt.
Comparing your earnings against your spending, also known as a debt-to-income ratio, is one of the most popular approaches for evaluating if you have too much debt. Lenders, for years, have looked at debt-to-income ratios to get a better grasp on a person's current financial picture to determine credit-worthiness.
Understanding the debt-to-income ratio
A debt-to-income ratio is a measure of financial stability calculated by dividing monthly minimum debt payments by monthly gross income. This calculation gives a straightforward depiction of your financial position. Typically, the lower your ratio, the better handle you have on debt.
Gerri Detweiler, author of "The Ultimate Credit Handbook" (ISBN B00005X1K2) and former director of both the Bankcard Holders of America, Salem, Va., a nonprofit consumer credit and advocacy organization, and the National Council of Individual Investors, Washington, D.C., has seen her share of the negative effects bad credit can have on an individual.
Monitoring your income and spending is the first step to understanding your debt
"Surviving credit crises becomes easier when you understand and accept your financial situation," says Detweiler. "Calculating your debt-to-income ratio gives you important information about if you're carrying too much debt for the money you're bringing in. It's easy to justify carrying debt but, at some point, you have to draw the line."
Determining your debtWhile different authorities offer slightly different methods to calculate debt-to-income ratios (see our calculator, Detweiler says whatever approach you take, thoroughness is imperative. The following is one example that includes your mortgage/rent payments in the equation:
Rationalizing your ratioNow that you have calculated your debt-to-income ratio, understanding what it means to you is the next step.
Lenders' view of your debt-to-income ratio
Many lenders establish whether or not you qualify for a mortgage, a car, or for credit based on your debt-to-income ratio. Lenders want to ensure they'll be paid back for their investment.
Avoid debt reaching a problematic stage.
Most mortgage lenders employ the "33/38 rule" when looking at debt-to-income ratios. This means that in order to qualify for a mortgage, your monthly house payment cannot surpass 33% of your gross monthly income and your total monthly debts (determined above) should not exceed 38%.
If your ratio is heading toward the financial danger zone, it doesn't necessarily mean lenders automatically will deny you a loan. "It's crucial to get your debt-to-income ratio as low as possible and keep it that way," says Detweiler. "However, with mortgage underwriting, for example, other compensating factors such as a hefty down payment or a good payment history can counterbalance. If anything, it may mean you pay more, but that's not even always the case."
Checking up on your debt-to-income ratioThe logical time to figure your debt-to-income ratio is when you're looking to purchase a house or apply for a credit card. However, staying aware of your ratio can help avoid debt reaching a problematic stage. Detweiler suggests recalculating your debt-to-income ratio on an annual basis or before or after major life events. "It's important to do a financial health check at least once a year," she says. "Yet, it's also important to do when contemplating a job change such as quitting a job or taking a pay cut; getting married or divorced; or making other financial changes."
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