Debt is a very important instrument in helping you amplify your returns if invested well. Whether you are looking at it from a personal or business perspective, debt or leverage can help you grow faster and achieve bigger things that may not have been possible if you relied only on personal equity such as savings.
Having said that, debt is a good servant but can be a bad master. You must learn how to control it and use it wisely. Without proper debt-to-income ratio controls, debt can quickly add up and spiral out of control. Persons, families, and businesses have often found themselves in situations where debt has piled up so much to a point where they cannot easily borrow more. This condition is known as” debt overhang”.
The debt-to-income ratio is a metric that monitors your monthly debt expenses vis-à-vis your monthly gross income. Debt expenses would be costs like your car loan payments, mortgage payments, credit card payments, child support, student loans, and other debt payments.
Take your total monthly debt payments (numerator) and divide them by your gross monthly income-before taxes (denominator). The ratio you get is your debt-to-income ratio. It is often expressed as a percentage.
Assuming your monthly debt repayment is £3,000 and your gross income is £10,000, your debt-to-income ratio will be 30% (£3,000/£10,000) %.
There are two types of debt-to-income ratios as summarised below:
- Front-end ratio: This type of ratio considers only the amount of debt repayments associated with housing expenses. This includes mortgage payments, insurance, and property taxes.
- Back end ratio: This ratio includes all debt payments less those listed on the front-end ratio. Most lenders use this ratio in determining the amounts to approve.
Importance of Debt-to-Income Ratio
Lenders including banks use a debt-to-income ratio to check how much of an applicant’s income goes into debt repayment. Using this information, the lender can
estimate the additional amount of debt their clients can take without straining when it comes to monthly repayments.
Lenders have their internal standards as to what they consider to be the optimal debt-to-income ratio. However, when applying for instant guarantor loans, you have a unique advantage in that even if your debt-to-income ratio is not as good, your guarantor or co-signer can use their healthy ratio to get your loan approved fast.
How Can You Lower Your Debt-To-Income Ratio?
Every borrower desires to have their loan application accepted. However, this can be tough especially with mainstream lenders as they insist on low debt-to-income ratios and good credit scores. However, bad credit loans lenders are less strict and can get you approved faster for amounts of even up to £25,000.
Having said that, any steps you can implement to lower your debt-to-income ratio are highly recommended. Here are 10 tips to start you off.
1. Increase your monthly repayments
If you increase the size of your monthly repayments, you will pay your debt much faster. This also means that your subsequent repayments will get smaller as you gradually get rid of most of your pending debt. However, it is important to note that making extra payments will require a solid financial plan.
2. Don’t take on more debt
If your debt-to-income ratio is already high, avoid taking on additional debt. This will only serve to worsen your financial position and potentially hurt your credit score. For instance, getting a new credit card or increasing your credit card expenditure can drastically increase your monthly debt repayments.
3. Postpone Big-Ticket Item Purchases
If you are thinking of making a big purchase such as a car or home, consider pushing your plans top a later date. Once you get to the point where a large chunk of your debt is repaid and your debt-to-income ratio is lowered, you can then consider getting a new loan to finance your big-ticket item.
4. Consolidate Your Debt
If you can bargain for a new lower-priced loan, debt consolidation is worth it. Simply add up all your existing debts and take a new loan that will clear all of them. This means you will remain with a single lower-priced loan to repay. With the reduced interest on the new debt, you can repay your loan faster or even afford larger monthly repayments. This will undoubtedly improve your debt-to-income ratio.
5. Account for All Your Income
It is not uncommon for people not to account for some of their incomes, especially the passive ones. If you have a side business or a second job or maybe you are collecting alimony or child support, ensure you include all that. It will go along way into boosting your income level and consequently your debt-to-income ratio.
6. Increase Your Income
Apart from just accounting for what you have, you need to look for other ways of increasing your incomes. If you are in wage-paying or salaried employment, you could ask for a raise. You could also take a second job or work overtime.
7. Use Balance Transfer Credit Cards
Credit card interest can add up quickly making it hard to pay off old credit card debt. With a balance transfer credit card, you get a new card into which you transfer the balance from the old card mostly at 0% interest for a given grace period. You can take advantage of the 0% window to repay your debt faster and boost your debt-to-income ratio. However, watch for the fees they charge if any and what the rate will be after the grace period is over.
8. Come Up With a Budget
You may be wondering if making a budget helps in debt management. You’ll be surprised it does, and very well at that. A budget gives you visibility into your incomes and expenditures and any surpluses if any. If you have surpluses, you can add them to your debt repayments to clear your debts faster. On the other hand, if you end up with a negative balance -income is less than expenses, you can reduce your discretionary expenses or assign them a lower priority.
9. Improve Your Credit Score
With a good credit score, you can get lower rates on your subsequent loan facilities. This can be a good strategy for debt consolidation. Some of the easiest ways to improve your credit score include honouring your debt repayments, paying up your credit card balances, avoiding taking on new debt, and paying up your other bills on time.
10. Be Careful of the Type of Loans You Take
There are different kinds of loans out there but not every loan is good for you. For instance, if you borrow from a loan shark, you will be stressed up with some even threatening to auction your items or hurting you. This can drain you psychologically.
You also need to be very careful about payday loans. They may be very attractive especially when in fix and need some quick money, but their interest rates are way too high. Instead of helping you control your debt levels, these loans can make you get stuck into a debt cycle.
Debt can be a real saviour when you are stuck and need to get cash quickly. However, you need to be vigilant on the amount and type of debt you take up. The debt-to-income ratio is a key control that lets you know how your debt payments compare to the income you bring home.
As you work to lower your debt-to-income ratio, your credit score will also improve and your chances of getting approved for more cost-friendly loans will increase. Follow the tips highlighted in this article to give you a headstart into reining in your debt and become financially healthy.