How Does Debt Management Ratio Work
When you use credit to buy things, it’s important to understand how debt management ratio works. This article will go into more detail about this, including what is a high DMRL, how to track your monthly payments, and tips for staying within budget!
The content in this article was written by Lisa from WiseOnMoney.org and these bullets and paragraphs were adapted and updated by the author. These thoughts may not be held by the owner of this website or others affiliated with this site.
We are sharing this information as part of our participation in the Credit Card Accountability Program (CCAP) which we hope will help people find ways to better manage their money. CCAP participants include free resources such as account templates, calculators, and finance tools.
Important reminder: If you need additional financial guidance than this, seek professional help before attempting to handle your own personal finances.
A debt management ratio is determined by dividing your total credit card balance by your monthly income.
A higher number means you have more credit card debt that must be paid off per month than what you can afford.
It’s important to note that even if you make enough money to pay off your debts, it may not be possible without using resources like credit. Having lots of loans can lead to long term financial problems.
That’s why it’s best to try to get rid of as many debt obligations as you can before trying to manage the ones you still have. Ways to do this are discussed at length in our article here.
If you find yourself with very high levels of debt, don’t worry about having a low debt management ratio!
Most people never get into serious trouble because they overspend but there’s always someone who has done so.
By learning how debt management works, you will know whether you are spending too much or if you just need to cut back on things for a little while.
Calculating your debt management ratio
The debt management ratio is calculated by taking all of your debts, including credit cards, loans, and other obligations, and dividing them into two groups — categorized as either good or bad debts.
Good debts are loans that you have to maintain for balance or pay off in full each month. These include bills such as rent, utilities, insurance, and loan payments such as student loans and mortgages.
Bad debts are things like credit card balances that you want to cut down on, or eliminate altogether. This includes what you owe per the terms of the credit card, any additional monthly fees associated with the card, and interest that has accrued over time.
By having more bad debts than good ones, your debt management ratio drops. A lower number means you’re better at paying off your debts than you think!
It’s important to note here that no matter how much money you make, it can never be enough if you keep large amounts of unsecured debt. This includes credit cards and loans- even if you earn a very high income, there will always be something you lack control over (in this case, yourself).
I know from experience because I once had the highest income level on my credit report, but still struggled to manage my debt due to an expensive house purchase I made.
What is a good debt management ratio
The good news is that you can have very high credit card limits if you manage your debts well. Having large credit line limits makes it easier to spend, but also poses greater risk for loan default.
By having less than 10% of your monthly income in loans, it becomes much more difficult to accidentally overspend because there isn’t enough money left at the end of the month to do so.
This helps prevent compounding effects of debt. For example, if you spent all your money on bills and groceries this week and only had $100 left at the end of the day, then you would be forced to wait until next week to buy something expensive. This keeps yourself from buying big things – or what we refer to as “balloon payment purchases” - which may seem easy in the short-term, but can backfire later.
A good debt management ratio will also help you stay within your means long term by forcing you to consider how much money you have available every day before spending it.
Will my debt management ratio affect my credit score
The most recent update to the FICO Score was released in May 2019, and one of the key components is your debt management ratio. This ratio looks at both your monthly payments towards debts as well as how much money you have left after those bills are paid.
Your debt management ratio can have an effect on your credit score because people use this information to determine if you will pay off your loans on time, if you will struggle to do so, or if you will go into bankruptcy.
Some lenders may consider a higher debt management ratio to be a warning sign that you might not be able to afford paying back your loan. They may decide that it’s best to give you more leniency by offering you a lower interest rate or even a new loan with no fees!
That’s why it's important to understand what things could impact your debt management ratio. It’s also important to know whether you need to make changes to ensure that you don’t exceed your budget and run out of cash before you can repay all of your obligations.
How to fix your debt management ratio
The term creditor is used for those who lend you money, such as a bank that gives you a loan to buy a car. These are called direct creditors. An indirect creditor is someone who owes money to another person or business that then loans it to you.
Indirect creditors include employers that give you credit cards, personal friends or family members who give you a good recommendation for collateral, and large businesses like Amazon or Walmart that offer VISA and MASTERCARD cards, respectively.
By having debt from several sources, it can be difficult to know where each creditor’s financial strength lies. Therefore, instead of just focusing on paying off one creditor at a time, a more effective way to tackle your debt is by using a tool called debt management ratios.
What is a debt to income ratio
The debt-to-income (or debt-to-cash flow) ratio compares your total debts with what you make, or how much cash you have after paying bills. This calculation gives you an overall picture of whether you are spending more than you earn, or if you’re in control of your money.
A higher number means that you spend more money than you make, which can lead to troubles in meeting your monthly obligations and staying within budget limits. A lower number indicates that you pay off loans faster, making it easier to put away extra money for future expenses.
You will want to track this information for both short and long term goals. For example, when buying a house, having less than $500,000 in credit card debt could help you qualify for a mortgage loan.
There are several different ways to calculate debt management ratio, with some experts agreeing that the best way is to use average daily balance (ADB) as the denominator. This is because it takes into account all of your credit card accounts, not just those with high balances.
Some other common numerators include monthly payments or minimum payment amounts on each account; quarterly statements or reports detailing how much you spend in relation to what you earn; bills paid directly through the creditor such as cell phone services; or last month’s pay stubs.
Any of these can be used to determine if your debt management ratio is higher than recommended. However, you should make sure to keep in mind whether or not this information is accurate since many times creditors will report false data.
It's important to remember that even though your ADB may be lower than suggested, this does not mean that you are able to carry extra debt for very long before risking financial disaster. Your income must remain consistent to avoid additional problems.
Calculating your debt to income ratio
The most common way to calculate your debt-to-income (DTOI) ratio is by taking all of your monthly debts, adding them up, and dividing that total by your monthly income.
Your monthly income can be calculated in two ways: average per pay period or net monthly income. Average per pay period means figuring how much you make each paycheck before taxes and other deductions, then averaging those numbers together to get your monthly income. Net monthly income is simply what you earn after bills are paid every month.
If you’re having trouble calculating your DTOI using either method mentioned above, use these tips first!
Tip 1: Use gross income rather than net income
In his article about paying off credit cards quickly, Joe Frey recommends using gross income instead of net income when calculating your DTOI. Gross income is actually the amount of money you made more than once during an entire year, not just the last few months.
For example, if you received a $1,000 salary in November and then got a $5,000 raise in December, your annual income would increase by $4,000. When calculating your DTOI, we want to include the whole year in our calculation, so we need to adjust your monthly income for this.
We do this by subtracting the cost of living from your monthly income.