Debt to Income Ratios
How Debt to Income Ratios Work
A debt to income ratio is a calculation that shows how much of your monthly income goes towards debt payments. This information helps lenders (and you) figure out how easy it is for you to 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 loan.
How to Calculate
To calculate your current debt to income ratio, divide all of your monthly debt payments by your gross monthly income.
You can also “back in” to a calculation of how much your monthly debt payments “should” be by multiplying your income by the target debt to income ratio.
Monthly debt payments are the required minimum payments for all of your loans, including:
- Auto loans
- Credit card debt
- Student loans
- Home loans
- Personal loans
Your gross monthly income is your monthly pay before taxes and other deductions are taken out.
Example: assume you earn $3,000 per month gross. Your auto loan payment is $440 and your student loan payment is $400. What is your current debt to income ratio?
Divide the total of your monthly payments ($840) into your gross income. $840 divided by $3,000 = .28. Convert to percentage format, which results in a 28% debt to income ratio.
Example #2: assume you earn $3,000 per month gross, and your lender wants your debt to income ratio to be below 43%. What is the maximum that you should be spending on debt?
Multiply your gross income by the target debt to income ratio. $3,000 times .43 = $1,290. All of your monthly payments combined should be less than $1,290. Of course, lower is better.
What’s a good ratio?
The idea behind debt to income ratios is affordability. Lenders want to be sure that you can comfortably cover your 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% as a maximum debt to income ratio. That said, many other lenders will let you go up to 55%.
When looking at payments, a “front end” ratio only considers your housing expenses, including your mortgage payment, property taxes, and homeowner’s insurance. Lenders often prefer to see that ratio at 28% to 31% or lower.
A “back end” ratio to total debt ratio looks at all of your debt-related payments. That ratio would include auto loans, student loans, and credit card payments.
For your mortgage to be a “qualified mortgage,” which is the most consumer-friendly type of loan, your total ratio must be below 43%. There are exceptions to this rule, 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 – 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 Ratios
If your debt to income ratios are too high, you’ll need to bring them down to get approved for a loan. There are several ways to do that, but they’re not always easy.
Pay off debt: paying off a loan will reduce your debt to income ratio because you’ll have one less monthly payment included in your ratios. Similarly, paying down credit card debt means your required monthly payments will be lower.
Increase income: any additional work you can take on before borrowing is helpful. But all of the income doesn’t need to be yours. 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 your cosigner is taking a 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 your loan is 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. Of course, 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 they 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 know what you’re doing with debt, they’re more likely to give you a loan. Your credit scores are used to evaluate your borrowing history.