What is Debt-to-Income Ratio?
The concept of your debt-to-income ratio is very simple: how much of your total monthly income is used to pay all outstanding debt every month? Debt-to-income ratio is assessed and used by lenders in almost every loan application to ensure that your aggregate debt obligations, including the one you are applying for, is not excessive.
Why Debt-to-Income Ratio Matters
Having too much debt in relation to income could increase the risk of being late in your monthly debt payments, default on some or all loans, and constrain your ability to pay for everyday life expenses such as food, clothing, transportation, health care, entertainment, etc.
Normally, lenders will not approve a loan request if doing so will result in a total debt-to-income ratio of 43% or higher. Ideally, debt-to-income ratio will be at or below 38%.
How Debt-to-Income Ratios are Calculated
See the example below of a debt-to-income calculation.
Gross monthly income (“Gross income” means income before taxes and other deductions)
- Wages: $4,800
- Rental income: $500
- TOTAL: $5,300
Monthly debt obligations
- Mortgage: $950
- Credit card: $35 (minimum monthly payment on the outstanding balance is generally used)
- Auto loan: $200
- TOTAL: $1,185
To calculate the debt-to-income ratio, take the total monthly debt obligation ($1,185) divided by total gross income ($5,300). In this case, the debt-to-income ratio equals 22%.
Before Applying for a New Loan
If you plan to apply for a new loan, I recommend that you take a look at your debt-to-income ratio from a more conservative perspective. This approach will give you more confidence in your ability to avoid issues repaying the new debt.
Here are some tips and ideas:
- Instead of using gross income, use your “net income” in the debt-to-income calculation. That is the income left for you, after taxes and all other deductions have occurred. This will give you a more accurate picture of the actual income you can rely on.
- Use a good monthly budget. If you have a budget, and maintain track of your expenses and obligations, you will have a more accurate picture if the new debt is manageable and what “trade-offs” you will incur with the new obligation added to the budget.
- Stick to the budget. If you maintain a monthly budget that is great, but if you have developed the discipline to stick to your budget, then you will be in even higher ground to avoid late payments or default in your obligations (especially if you maintain an emergency savings fund).
- Look into the future. Do you anticipate a change in circumstances that could negatively impact your financial position during the life of the loan(s) outstanding? If so, consider those!