The Purpose of Debt Ratio


Debt ratio is an important indicator of how well you are doing financially and typically measures the relationship between debt and income, or between debt and assets. Some people consider debt ratios more important than credit scores in showing overall financial health, because debt ratios may show overspending and over-borrowing. Although debt ratio isn't used to qualify for most consumer debt, mortgage companies still use debt ratio to determine how capable a borrower is of repaying a loan.

Calculating Debt to Income Ratio

You can calculate your debt to income ratio with relative ease. List all of your debt payments that you make regularly. Include all of your obligations, such as your mortgage and student loans, as well as credit cards. Calculate the total of all of these amounts. List your income from all sources and add it up. Divide the total of your debt payments by your total income, and write the number as a percentage. This is your debt to income ratio.

Calculating Debt to Asset Ratio

Debt to asset ratio is calculated much like debt to income ratio. List all of your assets individually, including the value of your home and any investment or savings accounts. List the value of your vehicles, using Kelly Blue Book or a similar service. Include the value of any salable assets, like jewelry or collections. In another column, list the total amount of all of your debts. Add both of these columns, and divide the total debts by the total assets. This amount as a percentage is your debt to asset ratio.

Loan Qualification

Debt to income ratios often determine if you are able to repay a loan, particularly when you are applying for a new loan. While credit cards and other consumer debt companies mainly look at your credit score, larger debts like mortgages or business loans usually calculate your debt to income ratio. Mortgage companies also calculate the ratio of your projected mortgage payment to income. A bank's ideal ratio may vary, but 36 percent total debt to income is generally the maximum acceptable ratio for a prime mortgage with the best interest rates.

Financial Health: Debt to Asset Ratio

Even if you are not looking for new loans, you should calculate and review your debt to income ratio for your own benefit. Monitor this ratio over time for changes, and look for it to decrease, or at least hold steady. An increase over time in the debt to asset ratio may mean that you are leveraging yourself too heavily. If your goal is to get out of debt, this number should decrease. If your debt to asset ratio is more than 100 percent, you have a negative net worth.

Financial Health: Debt to Income Ratio

Generally, a debt to income ratio below 36 percent is good, not only for loan underwriting, but for your general financial health. As the number increases, you may begin to have difficulty making your payments. You can decrease your debt to income ratio by increasing your income as well. Be aware of other signs of debt problems, such as late payments.

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