Even if you do not plan to apply for a loan, knowing your debt-to-income ratio can save you the day in the future.
The best way to understand your debt-to-income ratio is to think of it as your creditworthiness. This number (usually percentage) is one of the key factors that determine loan approval.
Your DTI represents your monthly debt obligations relative to your gross income. And when you apply for a loan, the lenders consider this number when deciding whether to approve you for it.
Simply put, the lenders want to know you’re not getting in over your head financially.
So, what a good debt-to-income ratio is, you might ask. If your ratio strives to 36% or lower, your profile is considered as not risky for lenders.
Personal loan lenders typically allow higher DTIs than mortgage providers.
In some cases, even with a ratio of 43%, you are still able to get a mortgage.
With a credit score of 700 and above, lenders will be more likely to offer you a lower rate on your loan. A low DTI will also help make your case. Yet, get ready to pay a higher interest rate.
How to Calculate Debt-to-Income Ratio
Odds are, you’ve done this job before. It’s difficult to live a month without knowing how much you have come in and how much you owe.
Thus, to figure out the debt-to-income ratio, the first thing to learn is how much you earn each month? Sum things up and you’ll get the gross monthly income. Second, how much are your total monthly obligations?
So, what is included in debt-to-income ratio? Payments such as student loans, car payments, mortgages or rent payments, minimum credit card payments, personal loans, etc. However, income taxes, health insurance and car insurance are not considered there. Once you know the numbers, divide your monthly debt payments by your gross monthly income. The number you come up with is your DTI.
To calculate your DTI, use the example of the debt-to-income ratio formula below.
DTI = your total monthly debt payments/your gross monthly income
The result? DTI is 35%
Experts suggest that the debt payments-to-income ratio should be a maximum of 43% to 50% to still qualify for a loan.
Sure, it all depends on the lender, loan requirements, your credit score, down payment and reserves.
However, according to the new Qualified Mortgage rule, the max debt-to-income ratio is 43%, with a lot of lenders wanting this number to be under 43%.
Once you think you’re done calculating your DTI, you should know that the devil is in detail here. The debt-to-income ratio comes up with two separate percentages known as the back-end and front-end DTIs.
The front-end ratio is your proposed housing payment, while the back-end one includes all monthly debts and is more important since it represents the risk you present to a lender. Nevertheless, some lenders may require you to stay below both limits.
How Lenders View Your DTI Ratio
Everyone knows that DTI is imperfect, but one thing it does is make an assessment of whether a borrower can repay.
Typically, lenders want to see your front-end ratio of 28% and the back-end ratio of 36%. Meanwhile, lenders may or may not consider your front-end ratio. The reason is simple, the back-end one gives lenders a big-picture view of your finances.
Different lenders have different DTI requirements, yet, the 28% rule for the front-end ratio is one of the most common.
In the example above, if your proposed monthly rent (or mortgage) payment makes $1,200 of your $6,000 in monthly gross income, your front-end ratio would be 20%. That means your total housing costs should not exceed $1,680 ($6,000 x 0.28 = $1,680).
Since the front-end ratio includes only your rent (or mortgage) payment, the back-end ratio represents all your monthly debts. Here comes also loan payments, child support, alimony, and credit card debts. Thus, applying the 36% rule, your total monthly payments in the example above should not be more than $2,160 ($6,000 x 0.36 = $2,160).
Yet, some lenders will allow you to apply for a loan even with a back-end ratio of 43%. Thus, according to the recent FHA guidelines, debt to income ratios for FHA loans is 31% front-end and 43% back-end.
Does Debt-to-Income Ratio Affect Your Credit Score?
Thought that your DTI can affect your credit score? Think again.
Even though your debt-to-income ratio reflects your financial health, it doesn’t hit your score. Just because the major credit reporting bureaus do not track your income, their credit scoring software has no data to calculate DTI ratios.
Debt in general affects both your DTI ratio and credit score. So, you’d better follow experts’ advice on keeping the utilization rate no higher than 30 percent of your credit limit. At the end of the day, you’ll avoid having a negative effect on your credit score.
Why Is Your Debt-to-Income Ratio Important?
Once your debt-to-income ratio is calculated, the lender sees a big picture of your financial health. If you’re not about to apply for a loan yet, knowing your DTI ratio is still important.
For you, that means the possibility to keep an eye on important numbers. For example, after some calculations, you’ve found that your debt is 60% of your income. Not a nice surprise. You understand that in case of any emergency, you’ll have a harder time keeping up with your debt liabilities.
For lenders, your DTI ratio means nothing but the level of risk to deal with. The number of 43% is acceptable debt to income ratio that will make you qualify for a loan. A higher DTI ratio means that you are more likely to default on a loan.
How to Improve My Debt-to-Income Ratio?
One thing is sure, there’s no ideal debt-to-income ratio. There’s always room for improvement. It always makes sense to lower your DTI.
You have two ways: first – to reduce your monthly debt, and second – to increase your income. The latter is often easier said than done. Although, if you could have a higher salary, why would you bother about your DTI?
So, one possible way to improve your debt-to-income ratio is to reduce your monthly payments. Sure, some loans such as student or mortgage loans are not something you can change on one, two, three. It will take months to reduce your monthly liabilities but result in a lower DTI ratio.
It takes time and effort to pay down the debt you already have, but the end result is worth the battle.