When it’s time to take out a mortgage or open a new credit card, one of the first things a lender or creditor does is check your debt-to-income (DTI) ratio. Generally, an acceptable ratio is 36%. Anything higher, and some lenders begin to worry you’re already carrying too much debt. Here, we offer five tips to get DTI down to a healthier ratio.
What is the debt-to-income ratio?
DTI calculates how much you owe in relation to your income. It’s an easy way for a potential lender to figure out how much debt you’re already responsible for and to figure out if you can afford to take on more.
How to calculate DTI
Calculating your DTI is simple. It’s a matter of adding your monthly debts and dividing them by your monthly gross income (the amount you earn before taxes). As you add up your debts, include things like:
- Mortgage or rent payments
- Auto loan payments
- Credit card payments
- Personal loan payments
- Homeowners Association (HOA) fees, if you pay them monthly
- Alimony or child support payments
You’ll notice the payments you’re adding up are often associated with debts that will one day be paid off. Don’t include things like utility bills, charitable contributions, daycare, or groceries.
Let’s say you earn $6,000 per month before taxes, and your monthly debts add up to $2,500. To calculate your DTI, you divide $2,500 by $6,000 ($2,500 ÷ $6,000 = 0.4166). The result is 41.6%, nearly 6% higher than “ideal.”
If you calculate your DTI and find it’s more than 36%, or you want to decrease an already healthy DTI even more, here are five ways to do it:
5 ways to lower DTI
1. Pay down high balances
The higher the balances on debts, the higher your DTI. Take a look at all your debts and figure out which one has the highest balance. Not only will chipping away at that balance get you closer to paying off the debt in question, but you’ll find that your DTI is reduced with each payment.
2. Lower interest on debt
The lower your interest rate, the faster you can pay the debt off in full. There are several ways to lower your rate. The first is to call the lender and ask for a reduction in the rate. If you’ve been working with a particular financial institution for years, they know your reputation for paying on time and may want to keep you as a customer enough to lower the rate.
Or, you can consider consolidating higher-interest debt into a single personal loan with a lower interest rate. Say you have three credit cards, each carrying an interest rate between 15% and 17%. If you can land a personal loan at 5% and use the funds to pay the credit cards off, you’ll save money, pay your debt off faster, and quickly lower your DTI.
If your credit score is strong, you also have access to some pretty great credit cards with 0% introductory offers. Here’s how these offers work: A credit card company offers 0% interest for a set period (typically, 12 to 18 months) to new customers. You use the 0% offer to pay off outstanding debt or transfer outstanding credit card balances to the new card. You save money by not paying interest as long as you pay the new credit card off in full before the promotional period ends. In addition, your DTI drops with each payment.
3. Put credit cards on ice
Sometimes the best move is to “stop.” Stop buying things because you want them rather than need them. Stop giving money away when you have debt you should be paying off. If you find yourself pulling out a credit card for non-necessities, consider putting your credit cards on ice. Some people have found that freezing their credit cards in a block of ice in their freezer provides them with the time they need to talk themselves out of unnecessary purchases.
4. Implement a ‘24-Hour Rule’
The fact there are so many tried and tested ways to avoid spending money is a testament to the number of people who’ve had to find clever ways to control their finances. One such method is the 24-Hour Rule. Let’s say you’re in a furniture store with a friend and see a buffet table that would look great in your dining room. It’s been discounted several times and is calling your name.
That’s okay. You’re going to run across a lot of things that appeal to you as you work to lower your DTI, and some of those things are going to be discounted. The 24-Hour Rule requires you to leave the store (without buying the buffet table) and to think about the purchase for a minimum of 24 hours before opening your wallet. Is it worth it to you to get deeper into debt? Are you willing to trade a lower DTI for a new buffet table?
And, if you’re thinking about paying cash, give yourself time to consider whether you’d be better off using the money to pay down existing debt.
5. Take on a side hustle you can enjoy
No one wants to hear they should take on yet another job, particularly when they’re already working hard to get by. But stick with us here for a moment. There are so many cool part-time hustles available today, it’s possible to find one that makes your heart sing a little. For example, if you play a musical instrument (you don’t have to be a professional), you can give lessons to a few kids a week. You can teach English to children in Asia. You can sell crafts that you usually give as gifts. If you can find a way to make money while doing something you enjoy, it’s a win/win. Use those funds to pay down debt and lower your DTI.
Lowering your DTI may take time and effort, but you’ll find it’s worth both. That’s because a low DTI makes it more likely you’ll have access to financial resources when you need them, and may help you rest easier at night.
The post 5 Tips to Lower Your Debt-to-Income Ratio appeared first on The Motley Fool
Original source: The Motley Fool
