Have you ever sat down and calculated your debt-to-income ratio? It’s a very simple calculation and could be very eye opening. The way you do this is by first adding up all of your recurring monthly debts — your auto insurance premium, minimum payments on your credit cards, rent or mortgage payment, taxes, student loan debt payments and any other loans you might have. Next, add up all of your gross income (not what you take home). Stop and think as this could be more than just your monthly gross pay. Do you receive gifts at Christmas, earn commissions or get a bonus? Add any of these up, divide by 12 and add that number to your monthly income. Now, divide your monthly debts by your monthly income, which will yield your debt-to-income ratio.
Lower is better
This is a case where lower is definitely better. For example, suppose you had $3000 in monthly debts and a $6000 monthly gross income. This would yield a debt-to-income ratio of 50, which would be much too high. Most financial experts believe you should keep this number to 36 or less. This means that if your monthly gross income was $6000, you should keep your recurring monthly debts to $2160 or less.
What if you have a number higher than 36?
In the event you learn you have a number higher than 36, you have some work ahead of you. You need to pay down those debts and fortunately there are ways to do this and you may be able to do it fairly quickly. Here are six tips for quick debt reduction.
- Use a debt consolidation loan
- Do a balance transfer
- Sign up for consumer credit counseling
- Borrow from your life insurance
- Tap your retirement account
Here are more detailed explanations of these tips…
Get a debt consolidation loan
If you were able to get a debt consolidation loan, you could pay off all or most of your existing debts. The reason this would help your debt-to-income ratio is because that new loan should have less of a monthly payment than the total of the debt payments you are currently making. There are two reasons for this. First, it will most likely have a much lower interest rate – especially versus any credit card debts.
Second, if you a refinance your existing mortgage, get a second mortgage or a homeowner’s equity line of credit, you will have more years to pay off the loan. Given this, you might be able to reduce your monthly debt significantly and in just a few days. As an example of this, if you owed $30,000 in credit card debts and got a home equity loan at 5% and for 10 years, your payment would be about $312.20 a month. In comparison, if you have $30,000 of credit card debt at 19%, your monthly payment is probably around $600. So by moving that debt to a loan, you would reduce your debts by nearly $300 a month.
Do a balance transfer
There is now any number of 0% interest balance transfer cards available. Some offer an interest-free period as long as 18 months. If you qualify for one of these cards and transfer all of your high-interest credit card debts to that new card, you would have much lower payments because you would not be paying any interest. All of your payments for that introductory or promotional period would be used to reduce your balance. Trading a monthly credit card payment of $500 or $600 (or more) for a $0 monthly payment would certainly help your debt-to-income ratio.
Consumer credit counseling is where you choose an agency or company where you will be assigned a debt counselor. This person will analyze all of your spending and your income. He or she will help you develop a budget if you don’t already have one and what’s called a debt management plan or DMP. Your counselor will contact your creditors and negotiate reductions in your interest rates. He or she will present your DMP to your creditors for approval. Assuming that they all approve it you won’t pay them any longer. You will send the credit counseling company or agency one check a month and it will distribute the required funds to your lenders. The payment you send to the credit counseling company or agency should be a lot less than the sum total of the monthly payments you’ve been making on those debts. So again, this would help with your debt-to-income ratio.
Borrow from your life insurance
Do you have what’s called whole life insurance? This is the type that has both an insurance and an investment component so that it builds up cash value over a period of time. If you have this type of policy, you should be able to borrow from it. The really good news is that you can pay back the money whenever you like or not pay it back at all.
Tap your retirement fund
If you don’t have a whole life insurance policy, you may be able to borrow from your retirement fund. If you have a 401(k), you should be able to borrow up to $50,000 or half or what’s in your fund, whichever is less. Unlike a life insurance policy, you would have to pay back this money and within five years. And you would have to pay interest on the loan but here’s the good part, you’d be paying interest to yourself. If you had $30,000 in credit card payments and use money from a life insurance policy or your retirement fund to pay it off, your monthly debts would be reduced substantially, which should help your debt-to-income ratio considerably. If you’d like more information about borrowing from a 401(k), here’s a short video you could watch.
Because it’s as important as your credit score
It really is important that you know your debt-to-income ratio and that if it’s too high, you do something about this. It’s not only a quick way to understand how you stand financially but it can play a key role when you apply for a loan such as a mortgage, a auto loan or a student loan.