Knowing your debt-to-income ratio is very important. Lenders use it to know how much debt you qualify for. Let’s look at what is the debt-to-income (DTI) ratio. The DTI is your total debt divided by your total income. The ratio is best calculated monthly.
For example, if your total monthly expenses are $3,900 and your gross monthly income is $10,000, then your DTI is 39% (3900/10000=0.39).
Lenders calculate your “front-end” ratio as a standard rule. Lenders calculate this by taking your monthly housing payment (principal, interest, taxes and insurance) and divide it by your gross monthly income. This should not take up more than 28 percent of your gross income (income before taxes). This debt-to-income ratio is called the “housing ratio” or “front-end ratio.”
You might be wondering about your other debt and if lenders also consider this when qualifying you for a loan. Yes, they do. Lenders will calculate the total remaining debt, which includes all debt of your debt commitments, car loans, student loans. and minimum credit card payments, together with your house payment, and divide that by your gross monthly income to arrive at the “back-end ratio.” Lenders prefer a back-end ratio of 36 percent or less. Sometimes lenders will allow the ratio to be 39%, but not always.
- 36% or less: Healthy debt ratio
- 37%-42%: Not bad. However, you should start cutting debt now before you get in real trouble.
- 43%-49%: Warning, you need to take immediate action.
- 50% or more: DANGER, you need to get serious about your debt.
You need to monitor your DTI because it will help you avoid the rising of gradual debt. Avoid impulse buying and routine use of credit cards for small, daily purchases. If not, these can easily result in unmanageable debt. When you are aware of your debt-to-income ratio, you can:
- Make wise decisions about what you buying using credit and taking out loans.
- You will see the benefits of making more-than-the-minimum credit card payments.
- More importantly, you will avoid major credit problems.
Remember that Lenders may use your debt-to-income ratio to determine whether you’re creditworthy. If your ratio rises above 39% (the warning zone), it may:
- Hinder your ability to make major purchases, (a car or a home).
- You will pay higher interest rates and not receive the best credit terms.
- If you need additional credit in case of emergencies, it can prove difficult to get the additional credit. (Remember that an Emergency Fund helps you avoid this issue.)
Your DTI ratio is a powerful indicator of creditworthiness and financial condition. Always know your ratio and keep it low.
How to calculate your debt-to-income ratio?
- Step one – Calculate your gross monthly income. If your income is inconsistent, estimate your gross monthly income by dividing last year’s annual income by 12.
- Step two – Write down and add up all of monthly debt payments.
- Step three – Divide your total debt by your total gross monthly income. This provides you with your DTI.