Some Clarity on Your Debt-to-Income Ratio

Some Clarity on Your Debt-to-Income Ratio
  • Opening Intro -

    Your debt-to-income ratio (DTI) is a measurement of your gross income compared against your total debt.

    It’s an important factor when you need to consider your financial options and for effective monitoring of your overall finances.

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It’s a necessary calculation lenders will use when you apply for a mortgage, credit card or a variety of loans to help determine whether to approve your application.

Your goal should be to keep it as low as possible. After all, the less you have to spend paying off your debts, the more income you’ll have to put towards a mortgage or other expenses.

Gathering the information to calculate your DTI may take a bit of investigative work. You will need to add together payments for your home, property, credit cards, auto, personal loans, student loans, alimony or child support payments and any legal or tax assessments; it excludes any debt that will be paid off within 6 months of normal monthly payments. Living expenses such as utilities, food and entertainment are also unreported for the purpose of calculating your DTI. Once you have your totals, it’s just a simple math equation: 

Total monthly debt payments ÷ Total monthly gross income = Debt-to-Income Ratio

To figure gross income, add your monthly gross income (and that of your spouse) before taxes or insurance deductions have been taken out, in addition to alimony or child support payments for a monthly total gross household income.

Let’s say that this figure is $12,000. Now take your car payment ($500) mortgage payment ($1,200) the minimum payment for two credit cards ($150) and student loan payments of $150 for a total of $2,000 in monthly expenses. Using the above equation, your DTI is 40%, or put another way 40% of your income is going to pay your debts.

What does your DTI Mean?

The point to remember is that lenders use your DTI to determine your credit-worthiness. An excellent ratio is anything less than 30%, indicating a significantly higher income than debt. A DTI above 35% is less than ideal and anything over 44% will make it hard to qualify for a mortgage as it shows too much debt in relation to income. Lenders will look a bit closer at your lifestyle and you may not be approved for the lowest rates or the best terms.

In the hypothetical example above, the DTI (40%) is dangerously high for mortgage lenders and on the border for other types of loans. Before venturing out to borrow or to refinance, it would be wise to lower the ratio. It may take a few months to see it drop, but the effort will be well worth a lower interest rate on a long-term loan or mortgage.

A side note to keep in mind is that your DTI cannot be too low; however if it’s a result of having no credit history you will find it extremely difficult to get a loan. If you do, you will most likely require a cosigner and pay higher rates or be offered a secured credit card that will require funds be maintained in a specific account for this purpose. This is why there is so much emphasis placed on establishing credit accounts; lenders want to know that you’ve had experience managing credit.

Lowering Your DTI

Focus your attention on paying off outstanding debt. One way, that may only need to be temporary, is to cut your entertainment expenses for a few months and use that savings to pay down some of the debt used to calculate your DTI ratio. Some ideas to cut expenses include reducing or eliminating your cable service, dropping the landline phone, preparing more home-cooked meals, driving the car less and learning to enjoy the simpler pleasures such as gardening, reading, crosswords, etc.

Increasing your income is not always a viable option. If, however, you are self-employed, you may be able to provide a higher income disclosure on your tax returns, which will in essence lower your DTI.

Front-end Ratios for New Mortgages

Banks have tightened restrictions for loans and mortgages since the financial crisis and recession. In an effort to avoid the disastrous outcome of the financial crisis of approving loans to consumers who were unable to repay, lenders are using a front-end formula that better demonstrates the ability to repay. Simply put, the total monthly housing expenses that you will have in the home you want to purchase is divided by your monthly gross income. In these cases, lenders are looking for a front-end ratio of no more than 28%. If the ratio is higher than that, you’ll need to shop for a cheaper home.

While both your credit score and your DTI are vital factors considered by lenders, they still have some leeway in whether they approve you for a loan. Demonstrating a long employment record, a history of job advancement and a healthy savings account may have a positive impact and sway a lender to approve your application. Each lender will set their own policies in place.

Keep in mind that just because you can be approved does not mean it is wise to follow through on a loan. If you’re already struggling to make ends meet on your current income, don’t add to that burden just because you can. A comfortable DTI ratio is generally below 36% and staying at that level makes life a little easier.

Christopher Arthur is a blogger and regular contributor to www.asapcreditcard.com who writes specifically on finance related topics. His primary focus is on credit card services and debt, but also enjoys sharing tips on building credit, frugal living, saving money and much more. He strives to provide educational resources to aide consumers with their finance and money management decisions.

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Categories: Debt Management