The formula for calculating your debt-to-income ratio is simple: monthly fixed expenses divided by gross monthly income (before taxes and deductions). If your result is a percentage greater than 36%, your credit score will be negatively affected because you are considered to have too much debt. This means credit card companies and banks will likely turn down your application. Of course, each lender sets its own policy. Some might only approve your loan if you have a ratio below 30%, while others will accept a higher one. But a general rule of thumb is to keep your debt-to-income ratio below 36% if you want to get financing.
Of course, financial experts consider a debt ratio of 36% to be way too high. The lower it is, the better, but generally, a ratio higher than 20% tells a credit counselor that you have too much debt and might be headed for financial trouble. Your goal should be to try and reduce your debt so that your debt-to-income ratio is 20% or lower. Once you do this, your credit score will increase, you will be able to save up an emergency fund with enough money in it to pay all of your living expenses for one year; and you will be able to start saving more for retirement.
How to Calculate Your Debt-to-Income Ratio
To calculate your score, you need to add up your monthly fixed expenses. Monthly fixed expenses include all debt, such as the following: house payment or lease, credit card and other revolving credit balances; car payments, alimony, child support, etc. Do not include grocery, telephone, and utility bills or any debt that will be paid off in the next few months. If your mortgage, car loan or credit card will be paid off two or three months from now, don't include it in the equation.
Gross monthly household income: $5,000
Fixed expenses: $1,560 [house payment $540.00 + car payment $370.00 + credit cards $250.00 + child support $400.00]
Debt-to-income ratio calculation:
$1,560 (total debts) / $5,000 (total income) = 31%
The above calculation shows that this person is headed for trouble. He needs to start paying down his debt rather than accumulating more.