ACCT-102 Lecture Notes - Lecture 1: Homeowner Association, Savings Account
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Could your debt be affecting your credit? Here’s how to tell if your debt is out of
proportion for your income.
Keeping your debt at a manageable level is one of the foundations of good financial health. But how
can you tell when your debt is starting to get out of control? Fortunately, there's a way to estimate if
you have too much debt without waiting until you realize you can't afford your monthly payments or
your credit score starts slipping.
What is debt-to-income ratio (DTI)?
Your debt-to-income ratio (DTI) is a percentage that compares your monthly debt expenses to your
monthly gross income. To calculate your debt-to-income ratio, add up all the payments you make
toward your debt in an average month. That includes your monthly credit card payments, car loans,
other debts (for example, payday loans or investment loans) and housing expenses—either rent or
the costs for your mortgage principal, plus interest, property taxes and insurance (PITI) and any
homeowner association fees.
Next, divide your monthly debt payments by your gross income per month (that’s your income before
taxes are deducted). Multiply that number by 100 to get your debt-to-income ratio as a percentage.
To calculate your debt-to-income ratio, divide your monthly debt obligations by your
monthly gross income.
For example, if you pay $400 on credit cards, $200 on car loans and $1,400 a month in rent, your
total monthly debt commitment is $2,000. If you make $60,000 a year, your monthly gross income is
$60,000 divided by 12 months for a total of $5,000 a month. Your debt-to-income ratio is $2,000
divided by $5,000, which works out to 0.4 or 40%.
Why is my debt-to-income ratio important?
Because it's important to lenders. Banks and other lenders study how much debt their customers
can take on before those customers are likely to start having financial difficulties, and they use this
knowledge to set lending amounts. While the preferred maximum DTI varies from lender to lender,
it’s often around 36%.
How to lower your debt-to-income ratio:
If your debt-to-income ratio is close to or higher than 36%, you may want to take steps to reduce it:
Increase the amount you pay monthly toward your debts. Extra payments can help lower your
overall debt more quickly.
Avoid taking on more debt. Consider reducing the amount you charge on your credit cards, and try
to postpone applying for additional loans.
Postpone large purchases until you have more savings. If you’re planning to make a large
purchase via a loan or by using a credit card, you may want to consider waiting until you have more
money in your savings account. If you make a larger down payment, for example, you’ll have to fund
less of the purchase with credit, which can help keep your debt-to-income ratio low.
Recalculate your debt-to-income ratio monthly to see if you're making progress. Watching
your DTI ratio fall can help you stay motivated to keep your debt manageable.
Keeping your debt-to-income ratio low will help ensure that you can afford your debt repayments and
give you the peace of mind that comes from properly handling your financial responsibilities. It can
also help you be more likely to qualify for credit for the things you really want in the future.