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A consumer's debt to income ratio can affect many factors.
The Federal Reserve Board refers to the consumer debt to income ratio as household debt service and financial obligations ratios. A consumer's debt to income ratio can play a role in a number of financial events including auto loans, mortgage approvals and credit card rates.
Factors
The consumer debt to income ratio is determined by two factors: monthly debt payment obligations and the amount of personal disposable income a family or household has. The income used is a person's income before tax, while both mortgage and consumer debt such as credit cards or automobile loans are considered consumer debt. Additional examples of consumer debt may include home equity loan payments, student loans, alimony and any other loan product the consumer is obligated to repay.
Importance
A number of financial institutions consider a consumer's debt to income ratio when determining whether or not to grant a credit product to an applicant. The debt to income ratio is also a factor for homeowners who are attempting to modify their mortgage payments. Financial institutions will examine an applicant's debt to income ratio to determine the likelihood that he would default on a credit product if finances got out of hand. A potential employer may also examine a debt to income ratio when doing a background check on an applicant.
Suggested Ratios
Although each financial institution has different lending standards, a debt to income ratio of 36 percent or less is a preferred industry standard. Institutions granting mortgages prefer that a mortgage payment take up no more than 28 to 31 percent of an applicant's income each month.
Lowering Debt to Income Ratio
For consumers with debt to income ratios above the suggested amount, lowering the percentage can increase the likelihood of obtaining a credit product in the future. To lower debt to income ratios, consumers may choose to pay a larger amount each month to their credit accounts, decreasing the total amount owed. A consumer may also choose to take on an extra job or additional hours in order to increase the income side of the ratio.
When examining an application for credit, many lenders look at the consumer's debt-to-income ratio as one of the deciding factors in approving an application. The debt-to-income ratio gives lenders a glimpse into the financial picture of a consumer and helps evaluate his ability to repay additional debts. Often consumers look for ways to decrease their debt-to-income ratios not only to receive new credit accounts but to also get out of debt
Increase Income
One of the most obvious ways to decrease a debt-to-income ratio is to increase the amount of income that is coming in on a monthly basis. This can be done by obtaining a second job or having a spouse that is currently not working obtain employment. If a consumer works in a job that has available overtime, taking additional hours is another way to increase income. Consumers may also think about doing freelance work or starting a side business to bring in additional funds. Increasing income can also provide additional funds to pay down debts.
Pay Down Debt
When trying to reduce a debt-to-income ratio, many consumers may consider increasing the rate at which debts are repaid. This can be done by putting the increase in income directly toward debt repayment or by simply paying more on monthly payments. One recommended option is to pay additional principal payments on any debt to reduce the overall amount owed. This will also cut down on the amount of interest that is added to the account. Some consumers choose to use the snowball method of paying down debt by paying all their extra funds towards one debt until it is paid off and then snowballing that payment into the next debt.
Pay Cash for Purchases
After establishing a debt reduction plan to reduce a debt-to-income ratio, it is important to pay for subsequent purchases with cash, checks and/or debit cards. Consumers should also postpone any large purchases until they have the savings to pay in cash or have the option to make a larger down payment to decrease the amount of credit needed to complete the purchase. This will reduce the likelihood of the consumer taking on any more debt before the ratio is reduced.
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