If you’re planning to apply for a loan or a mortgage, or just want to take control of your finances, you’re going to need to know about your debt to income ratio.
It’s a key measure lenders look at when you apply for a loan and will be a deciding factor on whether your application is successful or not.
So let’s look at debt to income ratio and show you how to calculate it.
Debt to income
Your debt to income ratio is a percentage of your monthly income that goes towards paying debts.
Lenders use this ratio to evaluate your ability to manage more debt. The lower it is the better, because it indicates that you have more room in your budget to handle additional loans or outgoings.
A higher ratio may suggest that you’re using a lot of your income to cover existing debts, making it riskier for lenders to give you more credit.
There’s both a behavioural and financial component to that.
If you’re already paying out a lot on debt, it could mean you’re not so good with money. This may indicate risk, which a lender would want to investigate further.
The financial component is obvious. If you’re spending all your income paying debt already, you’re unlikely to be able to handle more.
In a nutshell, a lower debt-to-income ratio is like having more financial breathing room, while a higher one is a signal that you need to be cautious about taking on additional debt.
Two types of debt to income ratio
To complicate matters slightly, there are two types of debt to income, front end and back end.
Front end debt concentrates on rent or mortgage, taxes, bills and essential outgoings.
Back end debt covers a much wider scope including how much you spend on entertainment, credit cards and generally living life.
Most lenders use back end debt as it gives a much clearer picture of your financial position.
How to calculate it
To calculate your ratio, add up all your monthly debt payments (like credit cards, loans, and mortgages) and divide that total by your monthly income.
Then, multiply the result by 100 to get the percentage.
For example, if your monthly debt payments are £1,000 and your income is £3,000, your debt to income ratio would be 33.33%.
This means that 33.33% of your monthly income is being used to pay off debts.
What is a good ratio in the UK?
A ratio is generally considered to be below 40%. This means that your total monthly debt payments should be less than 40% of your monthly income.
This isn’t set in stone as all lenders work differently but this is the figure commonly used in loan calculations.
For example, if your monthly income is £3,000, a healthy ratio would mean keeping your total monthly debt payments (including credit cards, loans, and mortgages) below £1,200 (40% of £3,000).
Having a lower ratio is even better, as it indicates that you have more financial flexibility and are not overly reliant on credit to meet your expenses.
Lenders often view lower ratios more favourably because they suggest a lower risk of financial strain when it comes to managing additional debt.
How to reduce debt to income
If you’re planning to borrow money in the near future and your ratio is a little high, you may want to reduce it to make sure you qualify.
For once, this explanation is simple. The only ways to it are earn more or pay off some debt.
I imagine it will be easier to pay off some debt than ask for a pay rise right now so that’s what I suggest doing.
Ideally, you want to pay off enough debt so that your new borrowing keeps you under that 40% threshold.
This mainly applies to loans as mortgage payments right now could easily push you over. If you can do it for mortgage payments too, even better.
The more you’re planning to borrow, the further below that threshold you’ll need to be to qualify for your loan.
