Moneylenders use your debt-to-income ratio to calculate your trustworthiness as an investment. This comes into play when you buy a home and apply for a mortgage. Therefore, it’s important to know how to calculate this ratio and what your personal ratio means for your financial prospects.
Here is a short guide on debt-to-income ratios for potential homeowners.
How to calculate it
In order to figure out your own debt-to-income ratio, you must first add up your monthly obligations. These include the ongoing payments you have to make each month that contribute to your debt. Examples of such payments include your car loans, insurance payments, credit card payments, student loans, and mortgages.
Divide this number by your gross income per month, which is the money you make before taking out for your taxes. That’s your debt-to-income ratio.
Consider the following example. Your mortgage is $1,000 per month, while your student loan payment is $300. Moreover, your car insurance and loan payment is $500, and your credit card bill is $500. This means that your debt obligations per month total $2,300.
If you make $7,000 a month, your debt-to-income ratio is $2,300 divided by $7,000, which is about 33%.
What does your debt-to-income ratio mean?
This number impacts how easy it is for you to get loans and to buy a house. Even if you don’t calculate your debt-to-income ratio yourself, your prospective moneylenders will.
To lenders, having a lower debt-to-income ratio increases your probability of making monthly mortgage payments on your new house. Therefore, prospective homeowners with a smaller percentage of debt-to-income will be considered more trustworthy and get better mortgage rates.
Though this ratio doesn’t affect your credit score directly, credit agencies do compare your credit balance with the total limit on all your cards. Most of the time, as the amount you owe increases relative to your credit card limit, the more likely it is that your credit score will go down.
A good ratio
Different lenders will have different standards regarding the required debt-to-income ratio for buying a home. However, the generally accepted debt-to-income ratio of is less than 35%, which indicates a manageable level of debt and a trustworthy borrower.
If the ratio is higher than 50%, many lenders will perceive you as less likely to pay off a mortgage or other loans.
What can I do about my high debt-to-income ratio?
Debt-to-income ratio is simply two numbers divided into each other. Therefore, the only way to improve your ratio is to change one of these numbers. For example, you could increase your income by asking for a raise, finding a better position, or taking extra work on the side.
However, decreasing your debt is more complicated. Here, you could consolidate your credit cards, negotiate a better rate on your car insurance, or change your payment plan on your student loans.
By renegotiating some of your monthly payments, you can automatically improve your debt-to-income ratio per month, without having to earn more.
Moneylenders and mortgagers look at your debt-to-income ratio to determine your viability as a borrower.
A ratio greater than 50% shows them that your expenses are too close to your total income to warrant the additional loan. In contrast, having a ratio less than 35% shows them that you’ve got your finances under control.
Lenders can vary in their response to your debt-to-income ratio. However, you can improve your bargaining position by earning more or renegotiating payments on existing loans to reduce your monthly expenses.
Regardless, this ratio is important to know, since prospective lenders will know it too. Calculating your debt-to-income ratio helps to determine how much bargaining power you have when negotiating your mortgage and looking for a home. It can also be helpful to avoid getting stuck with payments beyond your means.