Debt-to-income ratio and credit utilization ratio - Often people confuse between these two terms.
Reply honestly, haven’t you ever thought - Are they same? :-) No, they aren’t.
Though we need to consider both these terms to manage our finances well, yet they are different.
Continue reading to clear your confusions.
Debt-to-income ratio - An important assessment to take out a loan
Yes, you need to assess your debt-to-income ratio before you think of taking out a loan. It is better if you do the calculations yourself because your lenders and/or creditors will assess the figures before granting your loan request.
Debt-to-income ratio - What it is
It is a ratio that depicts your ability to take out additional debt after managing your existing debt payments.
DTI ratio - How to calculate
You can calculate it easily:
- Add your monthly bills that include your monthly house payment, loan payments, alimony or child support payments (if any), minimum credit card monthly payment along with other monthly payments on debts.
- Divide your total monthly bill expenses by your gross monthly income that is, what you get before tax deduction.
- In the result figure, move the decimal places to two places to the right.
- You get your DTI expressed in the form of a percentage.
A. Front-end (Housing) ratio
B. Back-end ratio
Try to have front-end (housing) ratio within 28% and back-end ratio within 36%.
To calculate your front-end ratio, just consider the expenses toward your mortgage or housing payments.
The DTI ratio or the back-end ratio denotes the percentage of your monthly income that goes toward paying back your debts and other financial obligations.
If your monthly earning = $6,000
Your monthly debt obligations (Auto loan - $400, Minimum credit card payment - $300, monthly mortgage payment - $1,200) = $1,900
Your DTI (Back-end ratio) = $(1,900 / 6,000) = 0.31 or 31%
Your front-end ratio = $(1,200 / 6,000) = 0.2 or 20%
The lower the ratio, the better for you, in both the case.
However, the lenders usually grant your mortgage loan request if your front-end DTI ratio is not more than 33% of your income and your total debt payments is within 38% of what you earn every month.
Tips to reduce your DTI ratio:
- Pay off your outstanding balance on credit cards and stay current on mortgage and other secured loans.
- If required, take professional help to consolidate or settle your unsecured debts to make them manageable and pay them off.
- Take out loans which you can manage comfortable and stay current.
- Refinance your mortgage loan if the current interest rate is low and reduce the monthly payments.
Debt-to-credit ratio - An important component of your credit score
When you apply for a credit card, the creditors often check your credit utilization ratio to assess whether or not you can manage more credit.
Credit utilization is also an important part of your credit score calculation.
Debt-to-credit ratio - What it is
This ratio is a measure of how much credit you’re using in comparison to how much is available.
Credit utilization ratio - How to calculate
Follow these steps:
- Add your overall credit limit that is, the limit set on each of your credit cards.
- Your outstanding balance on credit cards.
- Divide your total outstanding balance by your total credit limit and in the result figure, move the decimal places to two places to the right.
- It is your credit utilization ratio.
If your total credit limit = $20,000
Your outstanding balance (Credit card A - $4,000, Credit Card B - $1,500, Credit Card C - $500, Credit Card D - $200) = $7,200
Your debt-to-credit ratio (credit utilization ratio) = $(6,200 / 20,000) = 0.36 or 36%
Tips to reduce your balance-to-limit ratio:
- If you have an emergency fund, then you can tap a portion of your savings to repay your credit card debt.
- Refinance your credit card debt with a personal loan; that is, opt for credit card consolidation.
- Request your credit card issuers to increase the credit limit on your cards.
- Opt for a 0% or low-interest balance transfer card and repay the debt within the introductory period.
Tips to improve your DTI and credit utilization ratio together
Doing so, your chances of taking out a loan with better terms and conditions will increase.
Are you thinking that now you’ll have to remember a lot of things to bring down both the ratios? Well, there’s an easy way out, which can somewhat help in bringing down both the ratios to some extent.
How? Try to reduce the balance on your credit cards.
Here are 5 more tips to reduce your credit card debt:
- Plan a budget that helps you to save a substantial amount to pay off your credit card balances.
- Stop using your credit cards for the time being.
- Chalk out a suitable debt payoff strategy.
- Track each and every dollar you’re spending and stop unnecessary expenses.
- Try to increase your income so that you can repay debts fast.