A debt-to-income ratio is a personal finance measure that compares the amount of debt you have to your overall income. Lenders use the debt-to-income ratio as a way to measure your ability to manage the payments you make each month and repay the money you have borrowed. The ratio is calculated by dividing your total recurring monthly debt by your gross monthly income. For example, if your total recurring monthly debt is $2,000 and your gross monthly income is $6,000, your debt-to-income ratio would be 33% ($2,000 / $6,000 = 0.33, or 33%).
There are two ways to lower your debt-to-income ratio:
- Reduce your monthly recurring debt
- Increase your gross monthly income (or a combination of the two)
In the above example, the debt-to-income ratio was 33%, based on total recurring monthly debt of $2,000 and a gross monthly income of $6,000. If the total recurring monthly debt were reduced to $1,500, the debt-to-income ratio would correspondingly decrease to 25% ($1,500 / $6,000 = 0.25, or 25%). Similarly, if debt stays the same as in the first example but we increase the income to $8,000, again the debt-to-income ratio drops ($2,000 / $8,000 = 0.25, or 25%).
Of course, reducing debt is easier said than done. It can be helpful to make a conscious effort to avoid going further into debt by considering needs versus wants when spending. Needs are things you have to have in order to survive: food, shelter, clothing, health care and transportation. Wants, on the other hand, are things you would like to have, but that you don’t need to survive. Once your needs have been met each month, you might have discretionary income available to spend on wants. You don’t have to spend it all, and it makes financial sense to stop spending so much money on things you don’t need. It is also helpful to create a budget that includes paying down the debt you already have.
To increase your income, you might be able to:
- Find a second job or work as a freelancer in your spare time
- Work more hours or overtime at your primary job
- Ask for a pay increase
- Take on more responsibility at work
- Complete coursework and/or licensing that will increase your skills, marketability and salary
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