Before we discuss the good and bad debt ratio, let us first get to know what the debt ratio is? The debt ratio can be defined as the financial ratio that is applied in accounting to exhibit what portion of the business’s assets have been financed via debt.
If you have to find out the debt ratio of a company, all you need is to divide the company’s total debt with their total assets. Total debt will comprise of the short and long term liabilities of the company such as bank loans, lines of credit, and so on. The total assets will include intangible and fixed assets such as goodwill, property, and equipment, etc.
Debt Ratio = Total Debt/Total Assets
What is debt-to-income ratio?
It is your debt-to-income ratio that will assist your lenders to analyze how much more debt you can actually handle. As far as the calculation is concerned, DTI is calculated when your monthly income is divided by the total monthly debt payments, it also includes debt obligation, credit card payments, student loan payments, and auto loan, etc. Your credit report won’t carry your income, therefore as a part of a loan application; the lenders may ask you for a self-reported estimate or a document carrying validation of your income.
To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
For example, if you pay $1500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2000. ($1500 + $100 + $400 = $2,000.) If your gross monthly income is $6000, then your debt-to-income ratio is 33 percent. ($2000 is 33% of $6000.)
What is Good Debt Ratio?
Ideally, a company would have a debt ratio of 50%. This good debt ratio shows that the company got funded by both equity funding and debt. In case the company looks for extra funding from the bank, then the bank would ideally look at the company’s debt ratio. Let us assume the company’s debt ratio is 30%. Seeing lesser risk involved, the bank will happily offer a loan to the company.
What is Bad Debt Ratio?
In case the debt ratio of a company is higher, let’s say 80%, it certainly gives a red flag to the bank. With such a bad debt ratio, the company would seem to have most of their assets funded by the debt and this would suggest the bank that offering a loan to such a company can be risky.
What is the significance of Debt-to-Income Ratio?
Talking from your point of view, debt-to-income really plays a pivotal role. It is because it helps you understand how risky your financial standing is. Let us assume you are having a debt of 20,000 or 60% of your income, any hit to your income can lead to unfavorable results. If you are looking to accelerate your expenditure in other areas, you can have a tough time dealing with your debt payments as compared to someone with a debt-to-income of 25%.
Talking from the creditor point of view, debt-to-income is a key measure of risk. People with higher debt-to-income ratios are usually the ones who will default on their mortgages. Whenever you apply for a mortgage, the main part of the mortgage underwriting process is the calculation of your debt-to-income.
Why getting a new credit can be a problem with a High Debt-to-Income Ratio?
If you are having high debt-to-income ratio, it may not be an issue if you are borrowing sensibly along with that you are making your payments on time. But, if the numbers of debts are more in comparison to your income, then it can be a questionable situation.
Let us assume you are a starter and a high debt-to-income will indicate you have taken increased amount of debt overall. As the owed amount increases, your credit score will come down and this makes it harder to get loans. In addition to credit score, most of the lenders consider your debt-to-income ratio while approving a new credit card. This means if you have applied for a new credit card and the debt-to-income ratio is higher, the bank will sanction it, but you could face a denial even if you have an impressive credit score.
What are the things you should consider if your debt-to-income is too high?
If you have faced a refusal for your credit card because of a higher debt-to-income ratio, then it is the right time to make a switch to debt repayment mode. It’s not that you have to be worried about the credit card, but in fact, you should be concerned about your debt which has risen to a level where you are not being approved to have new credit, which is a clear sign that you are heading towards a financial crisis. You can deal with your debt; all you need is to follow the below-discussed tips to consolidate credit card debt –
- Cutting down the expenses is in your hands. In order to do this, you can analyze your monthly budget and see where you can cut. Purchase only necessary and important things.
- You can also opt to transfer your balance to a credit card having low interest.
- If you really want to make a significant progress with debt repayment, stop charging.