How to Calculate Debt-to-Income Ratio

Ever wondered about the optimum debt-to-income ratio? For that, let us first understand why this ratio is so important and how can we calculate it. Let us start by looking at the concepts.

Income is the total revenue which you earn periodically. This income includes not only your salary, but also returns on any investments that you may have made, interests you earn on your bank accounts, etc. So let us say that the total incremental money that you receive over a period of time (say a month) is your income.

Thus, you can calculate it as -

Salary (take home) + interest on investments + rent earned by properties if any + money earned on sale of investments/shares + other sources of income
= Total Income

Usually the total income is calculated for a period of a year (12 months), hence we divide this amount by 12 to get the monthly income.

Monthly Income = (Total Income / 12) ....................(I)

Debt is the money that you owe on account of loans, credit cards, etc. Let us classify debt as short term debt and long term debt. Short-term debt is like a credit card bill or an overdrawn bank account. These debts are incurred and fully paid off on a periodical basis.

Then there are long term debts like home loan and car loan on which you pay mortgage over a longer period of time. You pay the mortgage amount every month for a number of years to service this long term debt.

You can calculate debt as follows -

Monthly Rent + Monthly credit card payments + Monthly car loan payments + Other payments on outstanding expenses = Total Monthly Debt ..................(II)

Debt to income ratio is usually represented as a percentage to show what fraction of your income is spent on simply servicing your older debts. So for its calculation, the formula is -

(((Total Monthly Debt (as given by II))/(Total Monthly Income (as given by I)))X 100

This ratio helps you understand where you are spending your money and at what percentage. It is also important as lenders often study the ratio of a person and the loan is approved only if the ratio is favorable. It also tells you how much debt you have and if it is advisable to loan more.

If it is below 36%, it is generally assumed to be a safe percentage and lenders will not have much hesitation in forwarding the money to you. If it is between 37%-42%, you won't have trouble with obtaining credit cards but getting a loan may be a tough business.

And if it is over 43%, then it is in your best interest to get some debt management advice as soon as possible. Besides, at this level it is better that you fulfill all your old debt obligations before taking up any new ones.

If you no longer get calls from banks asking you to take credit cards, it is a sure sign that even they think that your debt is unmanageable and you are a risky business proposition.

So, now you know, how to calculate the debt-to-income ratio. Hope that this knowledge will help you manage your finances better!