The less you owe relative to your earnings, the better off you are

TWO major components of tracking how you're doing financially can be broken down into your income and debt levels.

Obviously, you'd like to have more income than debt payments, but even if you are making more money than you owe, how can you tell if that's good enough?

That's where the debt to income ratio can come in handy. This quick calculation can give you an idea of where you stand and can help you with other financial decisions such as figuring out how much money you can borrow to buy a house.

Ratios as a financial litmus test

Financial ratios don't give you a very detailed picture of your financial situation, but they can be used to quickly gauge how you're doing. In addition to the debt to income ratio, another easy ratio to calculate is your net worth.

With net worth you're essentially adding up your assets and measuring them against your liabilities. A positive number means you have more assets while a negative number means you have more liabilities. This number can help you track your financial progress from year to year.

Not only is the net worth calculation useful, but your debt to income ratio can come in very handy.

In fact, it's even used by many lenders to determine whether or not to extend a loan. If you have a head start and already know what your debt to income ratio is, you'll be better prepared to find the loan that's right for you.

Calculating your debt to income ratio

Add up all your debt and subtract it from your income. Some calculations may exclude things such as mortgage payments and property taxes, but to get a complete picture, it's best to include everything. Gather all your monthly debt obligations. This will include :

l Mortgage payment (including taxes, insurance etc);

l Car payment;

l Minimum credit card payment;

l Student loans;

l Child support;

l Any other debt obligations.

When you add these up, it will give you your total monthly debt payments. Keep this number handy. Now calculate your monthly income. Start with salary. If you receive any additional bonuses on a yearly or quarterly basis, divide it to get the per month number. Finally, add any additional income, whether through dividends or a side business. Total these all up and you will have your total monthly income.

To determine your debt to income ratio, take total debt payment number and divide it by total monthly income. That equals your debt to income ratio. For example, if you came up with a R2000 total debt payment number and monthly income of R6000, that leaves you with a debt to income ratio of 33%.

Why debt to income is important

Because you want it to be as low as possible. The less debt you have relative to your income, the better off you are financially. But it's also important in deciding what type of a house you can afford.

Lenders look at two key debt to income ratios when it comes to mortgages. First, the front ratio, which is the debt to income ratio that includes all housing costs. Then, the back ratio, which looks at non-mortgage debt to income ratio. Lenders would like to see your front ratio at 36% or less and back ratio at 28% or less.