The debt-to-income ratio is one of the most important financial ratios when applying for additional debt. When buyers apply for a mortgage to buy property, lenders take a close look at the ratio. Businesses must also provide debt to income ratio information when they apply for a loan. A key part of this ratio is unsecured debt, a measure of the specific debts that the applicant holds. If individuals known their income and expenses well enough, they can judge their debt-to-income ratio themselves before applying for credit.
The debt-to-income ratio is a comparison of the total income the individual receives per month with all fixed expenses the individual must pay per month. The income is measured as gross income, including wages, interest and all other payments received before applying reductions from taxes and other sources. Fixed expenses include typical debts that a homeowner must pay, but typically not utilities or grocery bills. This provides a percentage of monthly income that is used to pay for debts.
Unsecured debt is a term used to described debts that are not backed by collateral, or an asset with intrinsic value that a lender can claim if the debt obligation is not fulfilled. Debts like mortgages and car loans are secured. Unsecured debts included in debt to income ratios are often credit card accounts or alimony payments. Both types of debt must be included in the ratio for it to be accurate, but unsecured debts tend to be lines of a credit that operate more on a month-to-month basis, and are vital to include.
Fixed Expenses Specifics
The purpose of fixed expenses is to get a good idea of the monthly debts that must be paid. This means that unsecured debts are often more important than secured debts in the ratio. Secured debts tend to be for a specific duration, such as several years for a car loan. If the car loan is near being paid off, it should not be counted as a fixed expense, because the debt will not be recurring in the long term. A credit card debt, however, is a long term line of credit heavily associated with monthly payments and is often part of fixed expenses.
Healthy Debt to Income Ratios
There is no single rule for a healthy debt-to-income ratio. Some lenders prefer a ratio as low as 10 percent before considering making a loan, while others will accept a ratio as high as 30 percent. Typically, ratios approaching 40 to 50 percent are too high for any lender. In this case, unsecured debt is often the easiest type of debt to close or pay off, reducing the ratio and making it easier to qualify for further loans.