Debt to Income Ratio
The debt to income ratio determines how much debt you have in comparison to your income. This number is important for your lender, because it helps them determine your ability to pay back your debts. If you have a high debt to income ratio, that sends up red flags. Lenders look at two types of debt ratios.
Front end ratio: Shows how much of your income you spend on living expenses.
Back end ratio: Shows how much income you spend on your monthly debt obligations.
How to Calculate Your Debt to Income Ratio
Add your monthly payments such as a mortgage, student loans, auto loans, credit card payments, etc. and divide it with gross income.
Let me explain it with an example.
A person pays $600 for a mortgage, $200 for a car loan, and $200 for the rest of the debts each month. Monthly debt payments will be $600 + $200 + $200 = $1000, and gross monthly income is $3000; Debt to income ratio of such person will 33%. 1000/3000 = 0.33, and if the gross income is $2000 in this case, the ratio will be 1000/2000 = 0.50 or 50%.
One important thing to consider is that salaried or hourly employees will divide total monthly payments with gross income. Self-employed or business owners will use their net income for this calculation.
What is a Good Ratio?
A low debt to income ratio shows that the borrower has sufficient income to pay his expenses. Generally, lenders prefer debt to income ratio no more than 36%, but anything above 43% will disqualify your loan application.
Lenders view it this way:
35% or less DTI ratio
You have saved money after paying your bills. Lenders will be favorable toward your application.
You are managing funds appropriately, but you should work on making it lower. There is a great chance that lenders will approve your application, but they will demand additional eligibility criteria.
50% or more
You are spending more than half of your payment for debt payments, and you are not saving enough money to pay for handling more expenses. Lenders will not reject your application.
What to Do if it is too High?
If your debt to income ratio is high, there are two ways to lower it:
- Increase your income
You can increase your income many ways:
– Take an extra part-time job
– Investing in the business (this will raise your net income if you are business owner)
– Generate money from any other resources.
The more income you generate, the lower your ratio will be. While you are raising your income, do not take on any new debt.
- Pay off your debts
The second way to lower DTI is to pay off or pay down your debts. For this purpose, you should save more money and spend wisely. Make a budget to control your expenses. Avoid unnecessary shopping and eating out. As a bonus, that last bit will help you financially AND physically.