You hear about the debt-equity or debt-to-income ratio when making a budget or applying for a loan. But what exactly is it?
The debt-to-income ratio
The debt-to-income ratio compares your take-home payyour net monthly income after deducting taxes and pension plan contributionswith your debt. Creditors use this ratio to evaluate your ability to pay back a loan, that is, your creditworthiness.
How to calculate your debt-to-income ratio
To calculate your debt-to-income ratio, add up all your recurring monthly payments (rent or mortgage payments, home insurance, taxes, car payments, credit card payments, student loans, etc.) and divide the total by your net monthly income, including any monthly investment income you get.
When calculating your payments, don't include non-debt expenses, such as food or utilities (phone, electricity, transportation, etc.), though it can still be useful to know the total amount of these expenses because it can help you follow your budget.
What's a good debt-to-income ratio?
A debt-to-income ratio under 30% is excellent and a ratio of 30% to 35% is acceptable. A ratio higher than 40% could make creditors reject your application for an auto loan, student loan or mortgage. Plus, it's a sign you're in financial trouble!
The difference between your credit score and your debt-to-income ratio
Unlike your credit score, which shows your past credit behaviour, the debt-to-income ratio is a snapshot of your current financial status.
