How to Calculate Debt-to-Income Ratio

We continuously hear about people asking for what is the optimum debt-to-income ratio. For that, let us first understand the concept of a debt-to-income ratio, why it is so important and how to calculate a debt-to-income ratio. Let me start first by defining the concepts.

What is Income?
We all know what is income. Income is the total revenue which you earn periodically. This income includes not only your salary, but also returns on any investments, which 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 the income by

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)

What is Debt?
Debt is the money that you owe on account of loan or 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. Thus you can calculate debt by

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

How To Calculate Debt-To-Income Ratio?
Debt to income ratio is usually represented as a percentage. The intention of the debt-to-income ratio is to show what percentage of your income is spent on simply servicing old debts. So to calculate this ratio, the formula is

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

Why Do We Calculate Debt-To-Income Ratio?
A debt-to-income ratio is one of the ratios that help you understand where you are spending your money and at what percentage. It is also important as lenders often study the debt-to-income ratio of a person and the loan is forwarded only if this ratio is favorable. It also tells you how much debt you have and if it is advisable to take more debt. So now you know how to calculate your debt-to-income ratio. If your debt-to-income ratio 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. Besides, at this level it is better that you fulfill all your old debt obligations before taking up any new. 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. A debt of over 43% is impending trouble and it is in your best interest to get some debt management advice as soon as possible.

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