If you think that your credit score is important, you’re right. It will determine whether or not you can buy a home or a car. It also determines what interest rate you will receive when you do apply for a loan or credit card.
That’s why you need to understand what goes into your credit score. One of the most important components is the debt-to-income ratio.
What is a Debt-to-Income Ratio?
Chances are you have several different types of credit and debt. These typically include a mortgage, a car loan, and maybe a couple of credit cards. You might also have a personal loan.
When a potential lender looks at your credit, they want to see how much debt you have compared to how much money you make each month. For example, if you have a mortgage payment of $1,000 a month plus a $400 car payment and additional monthly payments for credit cards of $200, then your debt payments each month would be $1,600.
Then, if you make $3,500 per month before deductions, you would have a debt-to-income ratio of 45.7 percent.
So, to put it simply, your debt-to-income ratio is just your monthly debt divided by how much money you make each month.
Why Your Debt-to-Income Ratio Matters
Lenders use this percentage to determine how big of a credit risk you are. They make the assumption that the higher your debt-to-income ratio is, the more likely you are to miss monthly payments and default on loans.
This makes sense, actually. If you have a high percentage, you have less wiggle room, money wise, if you have an emergency or some other type of unexpected situation. This can put you in the position of having to decide between making a loan payment and paying for the emergency, which is why you need an emergency fund.
Creditors look for a ratio of 43 percent or less. If yours is above this level, you will find it very difficult to obtain credit and especially a home loan. Even a ratio near this level will hinder your ability to get the credit you need.
How to Improve Your Debt-to-Income Ratio
If you discover your ratio isn’t great when you do the math, you can take steps to improve it. While it isn’t always easy to find extra money in your monthly budget, you’ll want to work at finding it. When you do, you can use it to pay off as much of your debt as you can as quickly as you can.
Consider starting with your credit cards and pay them off. This is a smart financial move anyway, and once they are paid off, you can start adding extra money to your other payments such as your car loan, student loan or mortgage. If you can’t pay them off, here’s how to get a lower APR on your credit cards.
This is especially important if you are planning to buy a new home in the near future. The lower you can get your ratio, the more likely you will be approved for a new home loan. Besides, paying off your debts now makes each month a little easier when it comes time to paying the bills.
There are many things that go into your credit score, but your debt-to-income percentage is right at the top of the list when it comes to importance. By taking control of your debts today, you’ll find your future is much easier when it comes to finding and being approved for credit.
This information was brought to you by BetterLoanChoice
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