Know your finances

You may know that your credit score is an important factor when you apply for a loan. Did you know the total amount of debt you have is important too?

When you apply for a loan, lenders will look at something called your debt-to-income ratio. You can calculate this by adding up all your monthly debt payments and dividing it by your total monthly income. For instance, if you pay $500 toward your home, car and credit cards each month while bringing in $1,000, your debt-to-income ratio is .5, or 50%.

This is a quick way to see how much more debt you can afford to take on, and it's a good rule of thumb to keep it under 40%. When you're adding up all your monthly debt payments, you should leave off your costs for cable, car insurance, cell phone, electricity, entertainment, garbage, groceries, health insurance and water. 

 If your debt-to-income ratio were 100%, you wouldn't have any spare income to make payments on a new loan, so a lender is unlikely to approve your application. The lower your ratio, the better – and making improvements here will also help your credit score, as 30% of it is based on the amount of debt you have.

Try to avoid a debt-to-income ratio of 0%, though. Lenders want to see how you manage debt before they lend to you, especially that you can make on-time payments. That means you need to have some debt in order to build up a payment history. Revolving credit, like a credit card, is a good way to do this. When you pay off your home or car, those loans will fall off your credit report over time. Because credit cards are open-ended, your payment history will only grow longer, showing your ability to manage your money successfully.

Try to have only a couple of credit cards with large credit limits, and keep your balances low because as balances go up so does your payment, which impacts your debt-to-income ratio. If you started out with smaller limits as you were trying to build your credit score, you can ask to increase your limits later. If you close any credit card accounts as you pay off debt, keep the oldest ones because they show your longest history of behavior.

If you're carrying debt on your credit report, take some time this month to assess it and come up with a plan to improve your credit score and your debt-to-income ratio. You can also use free credit simulators, like Veridian's Credit Central, to come up with a plan to manage your debt.

Debt-to-income ratios are just one topic you can learn more about during Financial Literacy Month. Check out our other financial education resources – and if you're ready to talk about your individual financial situation, fill out the form below.

Veridian produces monthly articles about financial topics to help you learn more about your money. See our Financial Education page for more topics and resources.