Debt to income ratio explained

Don't neglect the debt to income ratio it can have major impact on your application.

Debt to income ratio is regarded as a significant element when it comes to analyzing your financial health. Although it does not have any direct effect on your credit score, it does play a crucial part when applying for a loan, especially when you apply for mortgage.

What is debt to income ratio?

            The debt to income ratio is showing your financial health in terms of your monthly income and the total monthly debt obligations you have. It is taking into consideration payments on your car loan, credit card, student loans and all other debt related obligations. Since it represents a ratio of your income and debt payments, it is a useful measure for banks. It is used by banks and lenders in general, to see how much additional debt you can service without any damage to your financial health. That is, debt to income ratio shows how much additional debt you could be able to repay, based on your income and current debt (if any).

            There is a difference when it comes to debt to income ratio in terms of mortgages. Meaning that you should be aware about two concept of debt to income ratio, front-end debt to income ratio and back-end debt to income ratio.  The front-end ratio is known as a housing ratio. This ratio shows the portion (percentage) of your income that would be reserved for your housing expenses (for instance: mortgage payment, real estate taxes).

            The back-end ratio is providing insight into the portion of your income which is needed to service all of your debt obligations on a monthly base. The debt obligations are taking into consideration credit card payments, car loans, personal loans, student loans, and all other debt obligations recorded on your credit report. It also includes your mortgage payments as well as housing expenses.

The importance of debt to income ratio

            Keeping track of the debt to income ratio is important for both, you and your bank. Analyzing your debt to income ratio on a regular basis could be a beneficial, because it can help you to avoid possibility for high indebtedness. Moreover, it will provide a clear picture about your debt level, and the effect from an increase in your debt. Thus, when you monitor your debt to income ratio, you are able to make a better decision regarding purchases on credit or applying for additional loans. Meaning that, it will serve as a method which will enable you to see if you are going to have problems in the future to service your debt obligations. In addition, having low debt to income ratio, can have a positive effect on the interest rate you are paying on a new loan. This is in a sense that, banks can define the interest rate on the bases of your risk level. Thus, a low debt to income ratio is signaling a lower risk level, which in turn could motivate your bank to lower your interest rate.

            Debt to income ratio is important to banks because it is a measure that will show them whether you pose a risk or not. This is in a sense that banks are able to calculate your ability to repay the outstanding debt or the financial ability to service a new loan. Therefore, through the debt to income ratio banks are able to decide whether you are a creditworthy or not.

What debt to income ratio do banks look for?

            Understanding the importance and the idea behind the debt to income ratio, imposes the need to understand what a good debt to income ratio is. Namely, what level of debt to income ratio is acceptable by banks and lenders? Additionally, you should know the debt to income ratio that will not leave you vulnerable to changes in your income and/or expenses level.

            A general rule is that your debt to income ratio should be 36% or less of your gross income. Having a debt to income ratio of 36% is considered to be acceptable because that way you could be protected against some unforeseen decrease in income or unexpected increase in expenses. Although you should keep in mind that the lower the ratio the better for you personally as well as for your loan application.

According to the Consumer Financial Protection Bureau you could have a maximum of 43% debt to income ratio and still be able to fulfill the requirements for Qualified mortgage.

How do you know your debt to income ratio?

            It is relatively easy for you to estimate your debt to income ratio. It is calculated by dividing your total monthly debt by your gross monthly income, or you could use the online calculator to estimate your ratio.

Debt to income ratio (DTI) = total monthly debt payments/gross monthly income

            For instance, let’s say that your monthly obligations are: mortgage $900, student loans $300, and $130 for a car loan. Thus, adding you debt obligations show that your total monthly debt payments are $1,330.  For instance, your gross monthly income is $5,000. Then it turns out that your DTI is 26.6% ($1,330 divided by $5,000).

            The above-mentioned calculation is to find out your DTI ratio. You could also calculate the maximum monthly debt obligation you should have based on your income, and the rule of 36 percent. Namely, you can multiply your monthly income with 36%. Say, you have a gross monthly income of $2,800. Then, multiplying $2,800 by 0.36 equals $1,008. This means that the maximum monthly debt obligation you could afford is $1,008.

What to do if your debt to income ratio is high?

Even though, you know the idea behind the DTI and how to calculate it, you should also know what to do in case your DTI is high. As it was mentioned, with high DTI you are on your way to reach a point when you are not able to service your monthly debt obligations. Thus, you should inform yourself about the possible ways of how you could lower your DTI.

  • Increase monthly income – one thing you could do is to increase your monthly income. You can do this either by taking on a second job or by asking for a raise from your employer.
  • Pay off loans early – if you have enough money, you should consider to pay off some of your debt earlier (about strategies for paying off a loan click here). By paying off part of your debt you will decrease the total monthly debt obligations.
  • Credit card usage – you should limit the usage of your credit card. Not using your credit card extensively, will limit the increase of your debt, thus you will be able to maintain a stable DTI ratio, and lower the same in the future. You will lower the DTI as you repay the outstanding debt on your credit card.

Debt to income ratio is regarded as an important element in your loan application. Namely, high DTI could signal that you are in the danger zone. Thus, you could run into problems when servicing your debt obligation. In contrast, having low debt to income ratio could enable you to negotiate lower interest rate. You should always keep track of this ratio, so as to know if you are on your way to worsen your financial health.

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