An important financial measure that lenders use Ė and that you can use too Ė is the debt-to-income ratio. Lenders use the debt-to-income ratio to qualify you for a loan because it tells the percentage of your income is spent on debt payments. If the ratio is too high, you may not get approved because the lender will assume you canít afford another debt payment. You, too, can use the debt-to-income ratio to gauge your financial wellbeing and to make plans for your future.
To calculate your debt-to-income ratio, youíll need to know your total monthly gross (before-tax income) and your total debts payments. For your monthly income, consider all your reliable sources of income, for example, wages from your job, alimony, and child support. If your income varies, use an average or the best estimate you can come up with.
Then, total your monthly debt payments including your mortgage, credit card minimum payments, loan payments, child support, alimony, etc. Donít include non-debt expenses like utilities, cell phone payments, or rent.
Once you have these two totals, divide your total debt payments by your total monthly income. You should get a number with a decimal. Multiply that number by 100 to change it to a percentage. The result is the amount of your income thatís going toward debt payments.
For example, if your monthly income is $4,000 and your total debt payments is $1,600, your debt-to-income ratio would be 1600 / 4000 or 40%.
In general, a debt-to-income ratio greater than 36% signals that you have too much debt. Not only will you have trouble getting approved for credit with this type of debt-to-income ratio, you might also struggle financially. The only way to lower your ratio, and therefore lower the pressure of your debt, is to increase your income or decrease your debt. Both can be difficult.
When theyíre approving you for a mortgage, lenders look at your debt-to-income ratio two ways. When your debt and housing expenses are all included in your debt-to-income ratio, itís called the back-end ratio. Lenders may also consider your would-be housing expenses, which they expect to be no more than 28% of your monthly income. If youíre shopping for a mortgage and you want to know what you can afford, multiply your monthly gross income by .28. The result is the total monthly amount you should spend on mortgage, insurance, and property taxes.
If youíre a renter and donít have a mortgage, your debt-to-income should be less than 10%, especially if you plan to go home shopping in the near future. Lenders may be lenient when it comes to student loan debt, both large amounts of other consumer debt arenít favorable for loan qualification. If a lender says you have too much debt to qualify for a loan, take some time to pay off some debt and reapply later.