Lenders look at your debt-to-income ratio and use it to determine if you can pay back your debt on a long-term basis. Your debt-to-income ratio in simple terms, is how much of your current monthly income goes to paying off debts.
The level of importance this plays depends on the type of loan: it will likely be very important to mortgage lenders, as opposed to smaller loans, as they want to ensure a loan won’t stretch your finances too far and you can actually afford to pay your bills.
Calculating your debt-to-income ratio is fairly simple and can help you take control of your finances.
What Is My Debt-to-Income Ratio? How Do I Calculate It?
To figure out your debt-to-income ratio, there are two simple steps:
- Add up all your monthly debt payments
- Divide that sum by your gross monthly income
Monthly debt payments you should include are housing costs and debts that would be included on your credit report, such as credit card payments (use the minimum payment as a guideline), student and auto loans. While monthly expenses such as utilities, groceries or gas generally affect your budget, you don't need to calculate them into debt-to-income ratio. Your gross monthly income is the amount you make before taxes and deductions are factored in.
$1800 monthly mortgage payment
$500 monthly car loan
$200 monthly student loan payment.
Based on that information, your total monthly debt would equal $2,500.
From there, you’d take a look at your income which is $60,000 annually, or $5,000 before taxes and other deductions.
That would make your debt-to-income ratio 50% (2,500/5,000 = .5, or 50%).
Why Debt-to-Income Ratio Is Important
Lenders assume that applicants with a high debt-to-income ratio will have trouble repaying their loans; and applicants with low debt-to-income ratios will be less risky. The lower your debt-to-income ratio, the greater the chance your loan application will be approved.
What Is a Good Debt-to-Income Ratio?
Standards can vary according to lenders. A range of 36% to 49% could use improvement and 50% or more limits your ability to borrow.
In addition, having a debt-to-income ratio above 43% can prevent you from landing a Qualified Mortgage. Qualified Mortgages protect you from harmful loan features like balloon payments, negative amortization and interest-only repayment periods. They also limit the amount of upfront fees your lender can charge you. If you want to own your own home, it could be in your best interest to stay far away from the 43% threshold.
Can I Improve My Debt-to-Income Ratio?
Paying more than the minimum payment on your loans will help you get faster results. Pay down your debt by making your payments on time (avoiding late fees) and in full, instead of only making the minimum payment and tacking on interest charges.
In terms of increasing your income, you can ask for a raise. If that’s not an option, you can take on side jobs, part-time work or online jobs. Also consider applying for a new job and negotiating a higher salary.
If you need assistance with your debt, you can consider talking with a counseling agency or debt management company. These may be able to help you with a debt management plan. You may also want to try and negotiate the removal of the debt from your credit report upon payment to any debt collectors.
Knowledge is power, so knowing what your debt-to-income ratio is then allows you to understand it. You can then make adjustments to your budget, debt and savings. This can help you get approved and be on your way to achieving your financial dreams.