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How to Reduce Your Debt-to-Income Ratio – Best Steps
Financial consumers may not give much weight to personal debt-to-income ratios, but they should.
That’s because debt-to-income ratio – the percentage of your gross income that goes to paying down debts – is one of the most important personal finance benchmarks, impacting everything from the amount of money in your bank account to your personal credit score.
“One’s debt-to-income ratio is simply the total of all monthly debt payments, divided by gross monthly income,” said Joseph Toms, president and CEO of Freedom Financial Asset Management in San Mateo, California. “This income typically is the amount earned in a month before taxes and other deductions.”
Debt-to-income ratio – also known as DTI – is a big influencer on lending and credit.
“DTI matters when it comes to borrowing money,” said Toms. “While it’s not the only factor lenders look at in evaluating prospective borrowers, it does provide an indication of someone’s ability to manage monthly debt payments. Lenders see higher debt-to-income ratios as signs that someone may be already trying to handle too much debt for the income they are generating.”
Plus, credit scoring agencies do look at credit utilization, which is how much of your total available credit you use. “Consequently, if your total debt includes substantial credit card debt, it will also be reflected in yourdebt-to-income ratio,” Toms said.
Here’s an example of how debt-to-income works in real life.
“Someone may have a monthly mortgage payment of $2,000, vehicle loan payment of $150 and $300 for other debts (totaling $2,450),” Toms said “If his/her gross monthly income is $7,000, then the debt-to-income ratio is 34%. If his/her gross monthly income were only $5,000, then the debt-to-income ratio would be 49%.”
Consequently, the lower your debt-to-income ratio, the better off you’ll be financially.
Cutting Your DTI Down to Size
While slashing your debt-to-income ratio is always a good idea, going about that task correctly takes discipline and ingenuity. Take those attributes to the debt-reduction table with these tips.
Be creative. The best way to lower your debt-to-income ratio is to start paying off your debts – the sooner and the faster, the better.
“Instead of buying furniture when they’re offering 0% interest for two years, then hit you with high interest payments after that, save up your money, and pay for it with cash,” said Steffa Mantilla, founder of Money Tamer, a personal finance website.
Opt for a debt consolidation loan – but do it right. Outside of increasing your income – which may be easier said than done – another way to reduce your debt-to-income ratio is to pay down your debt via debt consolidation.
“If your current income isn’t enough to cover a substantial pay down, you could consider a debt consolidation,” said Jory McEachern, Corporate Relations Manager for ScoreShuttle, a credit service based in San Diego, Calif. “It’s important to realize that a debt consolidation will only be effective if your new interest rate and monthly payment are lower than what you started with. Otherwise, you’re just moving debt around, which won’t impact your DTI.”
Stop overspending. A common mistakes consumers make when trying to lower their debt-to-income ratio is simply spending more than one can afford.
“Even if you’re able to increase your income, this shouldn’t give you a green-light to overspend,” McEachern said. “For the best DTI results, keep your spending low, your credit score high, and only purchase items you can afford to pay with ease.”
Focus on one debt at a time. A great way to reduce your DTI is to retire 100% of the balance on at least one financial obligation.
“For example, a recent college graduate might have eight federal student loans (one for each semester),” said Kevin Haney, president of Growing Family Benefits, in East Brunswick, N.J. “By paying off just one of these loans, you could lower your DTI by up to 12.5%, or one-eighth of all of the student loan debt.”
Don’t raid your emergency fund. A household emergency fund – usually about three-to-six months’ worth of regular income – can be a life saver in a genuine financial emergency. That’s exactly why it should be left alone in a debt-to-income reduction campaign.
“Therefore, never tap into your emergency fund to improve DTI,” Haney said. “An unexpected financial hardship could quickly lead to delinquency. Nobody is immune from disability, unemployment, job furloughs, and unpaid caretaker duties – especially during the COVID pandemic.”
The Takeaway on Debt-to-Income Ratios
Taking a diligent focus on household debt-to-income ratio, and curbing DTI significantly, is one of the savviest strategies in one’s personal financial arsenal.
Doing so not only cuts debt, it helps improve credit scores and breeds better overall personal financial management habits – all good outcomes for anyone looking to bolster their own money management scenario.
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Brian O'Connell has been a finance writer at TheStreet, TheBalance, LendingTree, CBS, CNBC, WSJ, US News and others, where he shares his expertise in personal finance, credit and debt. A published author and former trader, his byline has appeared in dozens of top-tier national publications.