Your debt-to-income ratio (DTIR) is the percentage of your gross income that is tied up in debt. Lenders often use it to estimate how much additional debt a borrower may be able to take on. But even if you’re not planning on borrowing money any time soon, knowing your DTIR can be beneficial. It will reveal just how much of your income goes towards debt and may provide the motivation you need to get your debt under control.
To calculate your DTIR, add the amounts of all your monthly debt payments (credit card, student loans, rent/mortgage, etc.). Take the total of these numbers, divide it by your monthly gross income (your income before taxes), and multiply it by 100 to get your DTIR as a percentage. For example, if your total monthly debt payment is $1,500 and your monthly gross income is $4,000, your debt-to-income ratio is 37.5% ($1,500/$4,000 x 100 = 37.5). Generally, a DTIR over 36% is considered risky.
So what’s your debt-to-income ratio? If it’s over 36%, debt reduction should be a financial priority. Here are two popular debt reduction methods that can help you get there.
The debt snowball method targets the debt with the smallest balance first. You pay as much as you can towards this debt while paying the minimum amount on your other debts. Once the smallest balance is paid off, all the money previously allocated for those payments is added to the minimum payment of the remaining debt that now has the smallest balance. This continues until all debts are paid off.
The debt avalanche is similar in method to the debt snowball in that you pay as much as you can towards one debt while paying the minimum on the rest. However, with the debt avalanche, you start with the debt that has the highest interest. Once it is fully paid, the money for that debt is rolled into your payment towards the remaining debt with the highest interest. Again, this continues until every debt is eliminated.
Which is best for you?
Compared to the debt snowball, the debt avalanche eliminates total debt sooner and pays less in interest. But despite it being a longer, more expensive way to fully eliminate debt, the debt snowball is a popular method that has helped many; it eliminates individual balances more quickly than the debt avalanche method, and these milestones can give people the motivation they need to stick with their debt reduction plan.
Ultimately, that might be the most significant factor: the debt payment plan that’s best for you – snowball, avalanche, or some other plan – is the one that you will follow through with to get that debt-to-income ratio under 36% and eventually down to zero.
This article is for purposes of information and education only, and is not intended as tax or legal advice. Consult your personal tax and/or legal advisor for information specific to your situation.
Covenant Trust Company® is a financial services company owned by the Evangelical Covenant Church and its affiliates. Our services are available to anyone in need of asset management, retirement planning, legacy planning, gift planning, or trust services. In addition, we seek opportunities to encourage and promote healthy financial habits, and keep a personal finance blog at www.covtrustblog.com.