Debt-to-Income Ratio (DTI) Explained
What is debt-to-income ratio?
Your debt-to-income ratio is all your monthly debt payments combined divided by your gross monthly income. This ratio is used by lenders to measure your credit worthiness. A friend recently asked me, how do they calculate my income? As in, how do credit bureaus know how much someone makes. To answer my buddy’s question; lenders and credit agencies get your income information from credit applications. In certain cases, they may use an estimated income based on a random designation like a zip code and/or job title.
Calculating debt-to-income ratio
Calculating your debt-to-income ratio is simple. Add up all your monthly debt payments and divide them by your gross monthly income. Gross monthly income is the amount of money you make before any deductions. Here’s an example; if you pay $1000 a month for your mortgage and another $500 a month for an auto loan and $500 a month for the rest of your debts, your monthly debt payments are $2,000. ($1,000 + $500 + $500 = $2,000). If your gross monthly income is $4,000, then your debt-to-income ratio is 50 percent. ($2,000 is 50% of $4,000).
What’s up with the 43%?
Mortgage Loan studies propose that debtors with a high debt-to-income ratios are more likely to default on loans. The 43 percent debt-to-income ratio in most cases is the highest ratio a borrower when looking to qualify for Mortgage. There are some exceptions which we won’t get into details about because it’s still very touchy. Your best bet is to try to keep your DTI under 30 percent. Flirting with the maximum number of 43 percent would be dangerous when borrowing. 36 percent is a much safer number, however the lower the DTI the better!
We already know lenders look at DTI as way to prove out credit worthiness but as consumers and people looking to secure our financial well-being, we should always be aware of our debt-to-income ratio as well. The better we manage our debt the better prepared we will be as situations may arise throughout the course of our lives. The lower your DTI the more flexibility you have when it comes to managing personal finances. Be aware of your personal finances and monitor your debt-to-income ratio!