Debt is a reality for most Americans. In fact, the Federal Reserve estimates that 77% of Americans carry some form of debt.1 As a vital part of daily life, debt helps us buy our homes and cars, send our children to college, and make home improvements. It’s important, though, to realize that not all debt is created equally.
Some debt can be considered “smart” debt because it helps us acquire assets that increase in value over time, such as a home, a business, or an education. Smart debt typically consists of installment loans with fixed monthly payments and a scheduled payoff date. It’s steady and predictable unlike revolving debt, like a credit card or line of credit, which is much more problematic.
The final feature of smart debt is that it is affordable, meaning that at your current income level, you will be able to afford the payments. Lenders use a simple calculation called debt-to-income ratio (DTI) to determine your ability to carry additional debt. DTI is expressed as a percentage and is calculated by dividing your total monthly debt payments by your gross monthly income.
Ideally, your DTI should be less than 43%. When it extends beyond that level, your current debt burden may be unmanageable, limiting your ability to take out new loans. According to the Financial Health Network’s 2020 Pulse Trends Report, nearly 30% of Americans carry more debt than is manageable.2
So, how do you achieve a more manageable level of debt? At the most basic level, you will want to reduce your debts and/or increase your income to get your DTI to move in the right direction. Some specific ways to improve your debt-to-income ratio include:
- Increase your monthly payments to lower your overall debt balance more quickly. Use an online debt calculator to see the impact of making bi-weekly or lump-sum principal payments.
- Avoid taking on any additional debt. This may require you to cut back on expenses in the short run and reduce the amount you charge on your credit cards.
- Postpone any large purchases until you have enough saved up for a larger down payment. Embracing delayed gratification will allow you to borrow less.
- Look for ways to increase your income through a part-time job or side gig. You may also want to ask for a raise, seek a promotion, or consider a job change to boost earnings.
- Monitor your progress by recalculating your debt-to-income ratio monthly and making any necessary adjustments. Look at short-term sacrifice for long-term gain.
To learn more about debt-to-income ratio and ways to achieve a more manageable debt load, explore the rich content of our financial education tool Enrich.