Finding your debt to income ratio is simple: take the amount of debt you owe monthly, divide it by your monthly income, and get a decimal that can be converted to a percentage by multiplying by 100. The same steps can be used to determine your annual percentage as well. Understanding what that ratio means, however, is a much harder task that most people don’t fully comprehend. Debt to income ratios are often used by banks and other financial institutions to judge your fiscal health. Recognizing what your percentage means will help you understand what banks are looking at when they see your finances.
The Three Levels of Ratios
By using the stop light method, green (good), yellow (caution), and red (risky), ranking debt percentages is made simple. The green zone is 15% or less, the yellow zone level is between 15 and 20%, and the red zone is greater than 20%. These different levels help answer the question of what is a good debt to income ratio. Staying in the green zone is ideal, and making sure the red zone is avoided will keep you out of a troublesome situation. Now, what exactly do these levels themselves indicate?
Note: These levels do not include debt from mortgages.
The Green Zone
Financially, the green zone is considered the safe zone. When your debt to income ratio is this low, you still have a significant amount of income to devote to other life sectors, such as housing, insurance, and food. While in this zone, if an unforeseen event, such as medical problems, were to arise, you potentially have the funds to cover the costs. Creating an emergency fund while in this zone is also more feasible. The green zone is also a place where you can be comfortable taking on another small amount of debt. Since your current debt is at a manageable amount, adding on another small amount of debt to what you already owe will be relatively simple to pay off. Keeping in this zone grants you the privilege to have a nearly balanced budget.
For example: you have an annual income of $60,000 (for sake of easy math). You have a monthly income of $5,000. If you are in the green zone, you owe $750 or less a month from your income to pay back your debt. After paying your monthly debt, you still have $4,250 to allot towards other expenditures.
The Yellow Zone
The next zone is for those with a debt to income ratio between 15% and 20%. Following the example from before, an annual income of $60,000 will owe between $750 and $1000 a month in debt. When in this zone, you are still most likely going to survive, even after paying off your monthly debts. Using self-discipline, along with a self-pay method, like a debt ladder or debt snowball, staying on top of debts at this level is completely fathomable.
While many people can work out a plan in this zone, it is still an area of caution. This is an easy point to slip and fall into even more debt. First, you have to ask yourself how you even got to this point in the first place. Was it a medical emergency? Did someone lose their job and payments could no longer be met? If you fear that you might falter at this point, you should seek out professional help. Companies who offer budget and credit counseling sessions often give a consultation for free. Seeing a counselor at this point can save you from sinking into a dark hole of overwhelming debt. They can help set out a budget and find places to cut expenses. If you have multiple places that you are in debt to that have a high interest on them, a counselor can also help find a debt management program to aid in your financial recovery.
The Red Zone
When you get to this level of debt percentage, you have reached the danger zone. Going with the example salary, you will owe $1,000 or more in debt every single month. At this point, your debt is overwhelming and you may not be able to afford that along with other living expenses. Though you might be able to balance both out at first, there will most likely come a point when you find yourself in a sticky situation. While in the red zone, you need to make sure your budget is as tight as possible. Seeing a credit counselor is almost necessary to make sure that you find every single place that you can spend less on to pay off your debt.
Since all of these zones have excluded mortgages, what is a good debt to income ratio on a mortgage? Instead of using the stop light method, debt to income ratios and mortgages are classified as front-end and back-end.
A front-end ratio is the percentage of your income that you put forth towards your housing costs. When going to get a loan for your house, the lender will take your annual income and multiply it by their front-end ratio to find the total you can pay towards your housing. Using the example salary of $60,000 and an “ideal” allotment of 25%, your front-end ratio should be $15,000 of your annual income to put towards your home. Monthly, that would be a maximum of $1,250 in housing.
On the other hand, the back-end ratio is a higher percentage that includes other debts you may owe, such as credit cards or other loans you have taken out. The back-end ratio will also include the front-end ratio in its calculation. Your current debt should not exceed the calculated amount or you face to possibility of your loan being denied. For example, if the back-end ratio is 40% (which includes the 25% front-end, leaving 15% towards other debts), your annual debt should not exceed $24,000 on a $60,000 salary. Your monthly debt, therefore, should not exceed $2,000.
Keep a Good Debt to Income Ratio
Understanding how to calculate your debt to income ratio and what that ratio means is incredibly important. Based on which “level” you are at, you should take different steps to pay off your debt. Keeping your ratio to 15% or less is ideal. Finding the perfect balance in your budget is key to taking care of your debts for good. If you feel as though you are overwhelmed with your debt, do not be afraid to seek help from a professional. Keeping your finances in check is one step closer to paying off those debts.