Debt-to-Income Ratios

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The debt-to-income ratio calculation shows how much of your monthly income goes towards debt payments. This information helps both you and lenders figure out how easily you can cover your monthly expenses. Along with your credit scores, your debt-to-income ratio is one of the most important factors for getting approved for a bank loan.

The Calculation

To calculate your current debt-to-income ratio, add up all of your monthly debt payments, then divide your gross monthly income by your total monthly debt payments.

You can also do a calculation to estimate how much your monthly debt payments should be relative to your income.

Multiply your income by a target debt-to-income level, such as 30 percent, and use the resulting debt percentage to guide your debt repayment strategy if you're looking to qualify for a future loan.

Monthly debt payments include the required minimum payments for all of your loans, including:

  • Auto loans

  • Credit card debt

  • Student loans

  • Home loans

  • Personal loans

The gross monthly income used in the calculation equals your monthly pay before any taxes or other deductions have been taken out.

Some Examples

Assume you have a monthly gross income of $3,000. You also have an auto loan payment of $440 and a student loan payment of $400. Calculate your current debt-to-income ratio as follows:

Divide the total of your monthly payments ($840) into your gross income:

$840 debt payments / $3,000 gross income = .28 or 28 percent debt-to-income ratio.

Now, assume you still earn $3,000 per month gross, and your lender wants your debt-to-income ratio to be below 43 percent. What is the maximum that you should be spending on debt each month? Multiply your gross income by the target debt-to-income ratio:

$3,000 gross income  * 43 percent target ratio = $1,290 or less monthly target for debt payments

Any amount of debt payments lower than the target would be ideal and a lower number would improve your odds with your lender.

What Qualifies as a Good Ratio?

Banks and other lenders use debt-to-income ratios to gauge affordability. Lenders want to be sure that you can comfortably cover your existing debt payments, especially before they approve new loans and increase your debt burden.

The specific numbers vary from lender to lender, but many lenders use 36 percent as a maximum debt-to-income ratio. That said, many other lenders will let you go up to 55 percent.

Lenders may look at two different variations of the debt-to-income ratio. When looking at payments, they may look at a front-end ratio, which only considers your housing expenses, including your mortgage payment, property taxes, and homeowner’s insurance. Lenders often prefer to see that ratio at 28 percent to 31 percent or lower.

A back-end ratio of income to total debt ratio looks at all of your debt-related payments. This means that you would include auto loans, student loans, and credit card payments.

For your mortgage to be a qualified mortgage, the most consumer-friendly type of loan, your total ratio must be below 43 percent.

This rule has exceptions, but federal regulations require lenders to show that you have the ability to repay any home loan they approve, and your debt-to-income ratio is a key part of your ability.

You’re the ultimate judge of what you can afford. You don’t have to borrow the maximum available to you, and it’s often better to borrow less. Borrowing the maximum can put a strain on your budget, and it’s harder to absorb any surprises such as a job loss, schedule change, or unexpected expense. Keeping your debt payments to a minimum also makes it easier for you to put money towards other goals like education costs or retirement.

Improving Your Stats

If your debt-to-income ratio is too high, you’ll need to bring it down to get approved for a loan. You have several ways to accomplish this, although you may need a certain amount of strategic planning and discipline.

Pay off debt: This logical step can reduce your debt-to-income ratio because you’ll have smaller or fewer monthly payments included in your ratio. Paying down credit card debt aggressively allows you to have lower required monthly payments to cover.

Increase your income: Any additional work you can take on before borrowing can help. All of the income doesn’t need to be yours, however. If you’re applying for a loan with a spouse, partner, or parent, their income and debt will also be included in the calculation.

Of course, that person will also be responsible for paying off the loan if something happens to you. Adding a cosigner can help you get approved, but be aware that your cosigner assumes some of the loan repayment risk.

Delay borrowing: If you know you’re going to apply for an important loan like a home loan, avoid taking on other debts until getting your home loan funded. Buying a car just before you get a mortgage will hurt your chances of getting approved because the large car payment will count against you. On the other hand, it’ll be harder to get the car after you get a mortgage, so you’ll need to prioritize.

Bigger down payment: A large down payment helps keep your monthly payments lower. If you have cash available and can afford to put it towards your purchase, see how it would affect your ratios.

Lenders calculate your debt-to-income ratio using income that you report to them. In many cases, you need to document your income, and lenders need to be confident that you can continue earning that income over the life of your loan.

Other Important Factors

Your debt-to-income ratio isn’t the only thing that lenders consider. Another important ratio is the loan to value ratio (LTV). This looks at how much you’re borrowing relative to the value of the item you’re buying. If you can’t put any money down, your LTV ratio won’t look good.

Credit is another important factor. Lenders want to see that you’ve been borrowing, and more importantly, repaying debt, for a long time. If they’re confident that you have handled your debt well, they’re more likely to give you a loan. They'll look at Your credit history and scores to evaluate your borrowing history.