Acceptable debt-to-income ratio
A debt-to-income ratio is the percentage of your debt compared to your income.
Your debt-to-income ratio has an effect on your credit score and your ability to borrow money for things such as a house or car or to obtain other personal loans. Many banks and financial institutions have established what debt-to-income ratio is acceptable for a loan to be approved.
Banks and lenders in the UK have different debt-to-income requirements and the ratio requirements of an institution may vary according to load type. Typically, the acceptability limit is around 40 per cent. The lower your debt-to-income ratio is, the better your chances of getting approved for a loan and the lower the interest rate for that loan is likely to be.
If your debt-to-income ratio is slightly above 36 per cent, you might be able to obtain loans, but you should try to eliminate some of your debt to bring the ratio down. If your debt-to-income ratio is above 50 per cent, you should take aggressive action as soon as possible.
Calculate your debt-to-income ratio
A variety of tools and calculators are available online to help you determine your debt-to-income ratio. You also can do the maths yourself if you prefer. To calculate your debt-to-income ratio, add up all your monthly debt and expenses, including rent or mortgage payments, credit card payments, car payments, car and home insurance premiums and other loans.
Divide that number by your monthly gross salary, including wages from all jobs, child support received or bonuses. Multiply the answer by 100 to get your percentage. For example, if your monthly expenses are £650, and your monthly gross income is £2,600, your debt-to-income ratio is 25 per cent (650 divided by 2,600, times 100).
Reduce your debt
There are two primary ways to improve or reduce your debt-to-income ratio. One is to reduce your monthly living expenses and use the savings toward paying down your debt.
Examine your monthly budget to determine whether you are spending regularly on things you can eliminate. Try walking or taking public transportation instead of paying for petrol, parking and car maintenance, or set up a car pool.
Talk to your creditors to try to negotiate lower interest rates or reduce the amount you owe. To avoid overspending, try using the envelope system recommended by analyst Dave Ramsey on his website. Designate one envelope for each living expense, such as groceries, clothing, dining out or entertainment.
Put a set amount of cash in each envelope each time you are paid or each month. When the cash runs out in a particular envelope, do not spend in that category until you get paid again.
Increase your income
The other way to improve your debt-to-income ratio is to increase your income . Besides the obvious means of improving income, such as finding a second job, asking for a raise or working overtime, you could hold a garage sale of items you no longer need, rent out a room in your house or take on odd jobs around your neighbourhood. Do not increase your spending habits while increasing your monthly income. Use that money to pay down debts, thus reducing your debt-to-income ratio further.