Debt-to-income ratio and credit utilization ratio - Often people confuse between these two terms.

Reply honestly, haven’t you ever thought - Are they same? :-) No, they aren’t.

Though we need to consider both these terms to manage our finances well, yet they are different.

Continue reading to clear your confusions.

Debt-to-income ratio - An important assessment to take out a loan

Yes, you need to assess your debt-to-income ratio before you think of taking out a loan. It is better if you do the calculations yourself because your lenders and/or creditors will assess the figures before granting your loan request.

Debt-to-income ratio - What it is

It is a ratio that depicts your ability to take out additional debt after managing your existing debt payments.

DTI ratio - How to calculate

You can calculate it easily:

• Add your monthly bills that include your monthly house payment, loan payments, alimony or child support payments (if any), minimum credit card monthly payment along with other monthly payments on debts.
• Divide your total monthly bill expenses by your gross monthly income that is, what you get before tax deduction.
• In the result figure, move the decimal places to two places to the right.
• You get your DTI expressed in the form of a percentage.

To calculate your front-end ratio, just consider the expenses toward your mortgage or housing payments.

The DTI ratio or the back-end ratio denotes the percentage of your monthly income that goes toward paying back your debts and other financial obligations.

The lower the ratio, the better for you, in both the case.

However, the lenders usually grant your mortgage loan request if your front-end DTI ratio is not more than 33% of your income and your total debt payments is within 38% of what you earn every month.

How much is too much debt-to-income ratio

I can say that 1% more than the 28/36 rule should be too much for you. Rather, you should try to lower your DTI a bit more than 28/36; the lesser, the better.

As already stated, the 28/36 rule means that you shouldn’t use more than 28% of your total income towards the housing expenses, which includes mortgage payments along with insurance payments. And, you should spend within 36% of your gross monthly income towards your overall debt payments.

You can use the debt-to-income ratio calculator to know whether or not your DTI is within the range. You just have to give the required inputs to the debt ratio calculator and it will show the required percentage.

How to lower debt-to-income ratio

Here are the 6 ways to lower DTI ratio.

1 Choose a good debt repayment strategy

Answer a question - What is the best way to reduce the debt load? It’s very simple. Pay them off.

So, choose a debt repayment strategy that you can follow to reduce debt.

This is a good way if you’re looking for how to quickly improve the debt-to-income ratio. It will give you somewhat instant results. This is something which you can figure out yourself. You won't have to wait for long to get it reflected on your credit report or score.

As you go on paying back debts, your DTI ratio starts improving.

Debt repayment strategies you can opt for:

2 Cut your expenditure as much as possible

Do you think there’s no way to cut your spending? Evaluate again. There must be some way to do it unless you’re practicing frugal budgeting.

So, where would you try to reduce spending?

Check out if you’re eating out often. If so, switch to a healthy alternative by cooking meals at home, and in turn, save money too.

A good way to reduce spending is to do shopping with cash. It is proven that once you start paying with cash, you can’t pay more since you feel that money is going out.

3 Look for ways to increase your income

When was the last time you had a talk with your boss to raise your salary?

What you can do is you can talk to accept a more responsible position, and in turn, get an increment.

Also, do your homework. Do you have to undergo any training to go to the next level? If so, do that and make yourself competent to the next level.

Another way to increase your income is to use your leisure time and earn extra. You can look for part-time income opportunities online which you can do from home. This way, you can earn at the comfort of your home.

Now, whatever amount your increment is or the amount you’ll be able to earn extra, use it to reduce your debt load.

4 Reduce your grocery budget

What should be the average cost of food per month for 1 person? It is around $125 per person per month.

So, you can calculate the grocery budget for a family of 4 per month. It should be within $500.

Check out how much you’re spending now; if more, try to reduce your grocery budget.

How will you do that? Here are a few tips to lower DTI ratio by lowering your grocery budget.

5 Negotiate to reduce interest rates as much as you can

You can reduce the interest rates on your debts by negotiating with the creditors.

For example, if it’s becoming difficult to repay a credit card, you can explain your financial situation to your creditor and negotiate an alternative plan.

Likewise, if the interest rate on your mortgage is higher than the current market rate, you can refinance your existing loan with a new one.

6 Borrow from your retirement accounts if you want to repay fast

This should be your last resort to lower your debt-to-income ratio fast. Take out a loan from your retirement account.

However, if you withdraw from your retirement account, you usually would have to pay a penalty. And, make sure you pay back the amount as fast as possible.

Some more tips to lower your debt-to-income ratio:

Debt-to-credit ratio - An important component of your credit score

When you apply for a credit card, the creditors often check your credit utilization ratio to assess whether or not you can manage more credit.

Credit utilization is also an important part of your credit score calculation.

Debt-to-credit ratio - What it is

This ratio is a measure of how much credit you’re using in comparison to how much is available.

Credit utilization ratio - How to calculate

Follow these steps:

• Add your overall credit limit that is, the limit set on each of your credit cards.
• Your outstanding balance on credit cards.
• Divide your total outstanding balance by your total credit limit and in the result figure, move the decimal places to two places to the right.
• It is your credit utilization ratio.

What is a good credit utilization ratio?

Ideally, the best ratio can be 0%, that is, you’re not using your credit cards at all. But, that won’t help you to improve your score.

The reason being that one of the components of your credit score is types of credit you use. It is better if you use your cards responsibly. That is, use the credit cards and pay the bills at every billing cycle.

However, you shouldn't use more than 30% of your credit limit. Anything beyond this can affect your credit score negatively.

If the ratio is too high, it can drop your score more.

Therefore, even if you pay your entire outstanding bills every month, don’t use more than 30% of your credit limit, in any of your cards, at any point in time. If required, you can pay a portion of your bill and swipe your cards again, so that your utilization ratio is always within 30%.

Consequences of a high DTI ratio

Before talking about the ways to lower your debt-to-income ratio, know a bit about the consequences of a high DTI ratio.

Tips to reduce your balance-to-limit ratio:

• If you have an emergency fund, then you can tap a portion of your savings to repay your credit card debt.
• Refinance your credit card debt with a personal loan; that is, opt for credit card consolidation.
• Request your credit card issuers to increase the credit limit on your cards.
• Opt for a 0% or low-interest balance transfer card and repay the debt within the introductory period.

How to lower your DTI and credit utilization together

Doing so, your chances of taking out a loan with better terms and conditions will increase.

Are you thinking that now you’ll have to remember a lot of things to bring down both the ratios? Well, there’s an easy way out, which can somewhat help in bringing down both the ratios to some extent.

Here are 5 more tips to reduce your credit card debt:

• Plan a budget that helps you to save a substantial amount to pay off your credit card balances.
• Stop using your credit cards for the time being.
• Chalk out a suitable debt payoff strategy.
• Track each and every dollar you’re spending and stop unnecessary expenses.
• Try to increase your income so that you can repay debts fast.