What is the suggested debt to income ratio percentage rate? It sounds like one of those boring economic terms that only really concerns those who work in finance or government, but in reality it’s something that everyone should understand about their own finances. Calculating your debt-to-income ratio may take a little time, but it’s not difficult to do and it can be an extremely useful way of knowing where you stand when it comes to your household finances.
What is the debt-to-income ratio percentage rate?
The ‘debt-to-income ratio percentage rate’ sounds like one of those boring economic terms that only really concerns those who work in finance or government, but in reality it’s something that everyone should understand about their own finances. Calculating your debt-to-income ratio may take a little time, but it’s not difficult to do and it can be an extremely useful way of knowing where you stand when it comes to your household finances.
Knowing your debt-to-income ratio percentage rate can also give you an indication of how likely you are to be approved for credit, particularly for a mortgage or other large loan. This is because lenders like to see that you’re able to pay for credit installments without getting into difficulty, and they’ll use this debt-to-income ratio calculation as part of their decision making process.
The debt-to-income ratio is shown as a percentage and shows exactly how much of your monthly income goes towards ‘debts’. The word ‘debt’ here may be slightly misleading, as it does not exclusively mean loan payments and credit card installments – although it does encompass these. Any essential payment you make can be classed as a ‘debt’ in this case, so your mortgage/rent payment, insurance payments etc. should also be calculated as part of this.
Before you reach the section on how to calculate your debt-to-income ratio, which you can find at the end of this post, you’ll need to collect some information about your current financial situation. Just as you need all the correct ingredients to make a pie, you also need your financial ‘ingredients’ to find your own debt-to-income ratio. You’ll need to know how much you spend on housing (rent/mortgage payments), credit installments (i.e. loan payments, credit card payments, car payments, Christmas debts etc.) and bills on a monthly basis. You’ll also need to know how much you earn each month. Include all income; salary, benefits, tax credits, earnings from savings interest etc. in this calculation.
When you want to obtain credit, perhaps in the form of a mortgage or loan, how much can I borrow? is a common question and one which can be difficult to answer. This is because every lender will have a slightly different set of lending criteria and so you may be approved for a certain amount by one lender, whilst another may not agree to lend you much (or anything) at all. As a general rule, if you have a debt-to-income ratio percentage of 49% or above, then this is classed as having financial troubles and you may find that you are turned down, particularly if you are applying for a mortgage.
In the UK (since June 2014) the specific debt-to-income ratio for mortgages should be no higher than 45%. This means that your mortgage alone cannot take up more than 45% of your income. The Bank of England implemented this number in order to prevent house prices rising quite so rapidly, and mortgage providers must be mindful of this when processing applications. If you want to get a mortgage one day or if you have one now and you’re shopping around for a better deal, understanding this number and what it means to you can greatly help your chances of success.
For instance, you may find that your other debts prevent you from being able to comfortably pay a mortgage, so debt consolidation may then become your short-term plan of action. This can help to bring down your debt payments whilst also simplifying the process – rather than paying for 4 separate debt payments each month, for example, you could amalgamate these into one single payment. Debt consolidation simply means paying off your smaller debt balances early by using a larger loan. You’ll then only pay the loan installments for this single loan and if you do your research to get the best deal you can, this may be a much smaller payment overall, thus freeing up some of your income to create a better debt-to-income ratio.
Now that you’ve got a better idea of what a debt-to-income ratio means for you and what you need to be able to calculate it, this is how you can find out your own:
Start with your debts. Add up all of your monthly ‘debt’ payments (if you would prefer to do this weekly or even annually, then just make sure your income is calculated within the same timeframe. For example, if you are looking at your weekly debt payments then use your weekly income for the next part) – it may look something like this:
Total monthly debt payments: £1300
This means that every month, this much money is spent on your essential outgoings. Next, you’ll need to calculate your income. Use payslips and previous bank statements to work this out if you are unsure.
Total monthly income: £2350
Once you have this information, you need to divide your debt by your income. In other words, with this particular example, you’d divide 1300 by 2350. This gives a result of 0.55, or 55%. In this case, the debt-to-income ratio is higher than the general rule of 49% mentioned above. However, the mortgage payments alone make up just 29% of the total monthly income, which brings it well below the 45% limit imposed by the Bank of England. When you do your own calculation, it’s important to keep debt consolidation in mind as this may help to improve your own percentage and your general financial health.
Of course, if your number comes out higher than the 49% ‘limit’, this doesn’t necessarily mean that you are in financial difficulty. Many households in the UK have a high debt-to-income ratio, but this doesn’t necessarily mean that all of these households are struggling financially. You may well pay out more than 55% of your income on debts, but the remaining income can be well managed enough to ensure this isn’t a problem. If this is the case for you and you’re happy with your current financial status, then there’s nothing to say you cannot continue. However, it is always beneficial to consolidate or pay off debts if you can so that – if you do require credit one day – your debt-to-income ratio will not prevent you from borrowing what you need.