Debt-to-income Ratio – Why It Matters to Home Buyers
If you ever wondered how your debt compares to your income and whether your income is sufficient to cover your debt payments, then you need to calculate your debt-to-income ratio.
The debt-to-income ratio is defined as the percentage of a consumer’s monthly income that goes towards debt payments. Not only can borrowers use this useful metric to plan financially, but lenders also use the debt-to-income ratio to evaluate a loan application.
The debt-to-income ratio is calculated by dividing all the debt payments that a borrower makes monthly by the total gross income of that person. Multiplying this fraction by 100 gives you the debt-to-income ratio in a percentage form.
The monthly income can include income from a job, alimony payments, income from investments, or bonus payments.
Resources:
- Real Estate Investing School: How to Retire on Passive Income
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- Rental Properties Made Simple
- Personal Finance School: How to Maximize Money
Calculating the debt-to-income ratio
So, for example, if a borrower is using two credit cards, and if the monthly payment on the outstanding dues is $100 on the first card and $200 on the second card, then the total debt payment is $300.
If that person earns $1000 every month, then the total gross monthly income is $1000.
So, the debt-to-income ratio is then $300/$1000, which is equal to 0.3. Multiplying this decimal number by 100 gives you 30%. So, the debt-to-income ratio in our example is 30%.
How do lenders use the debt-to-income ratio?
Lenders pay particular attention to your debt-to-income ratio. It has historically proven to be a good indicator of creditworthiness. Research has shown that borrowers with a high debt-to-income ratio tend to end up having difficulties repaying their debt.
Whenever you request a home loan, an auto loan, a student loan, or any type of personal loan, the lender will first analyze all of your existing debts.
All your monthly debt payments are found and added.
Then, your income is evaluated based on the employment information and tax returns that you submit. Finally, your debt-to-income ratio is calculated and it is analyzed in conjunction with your credit history.
If the lender feels convinced that you are capable of repaying back the loan which you are requesting, given your current financial situation, then the loan is approved. If your debt-to-income ratio is deemed to be too high, then the lender may consider such elevated levels as potential financial stress and you could be turned down for the loan.
How much should the ratio be?
The Federal Reserve estimates that a debt-to-income ratio above 40% is financially risky territory. A debt-to-income ratio below 20% is considered to be low and will improve your chances of getting a loan at decent terms. Each lender has its own internal debt-to-income ratio benchmarks and the thresholds vary for every lender and the type of loan as well.
Personal loans and unsecured loans work with borrowers who have a relatively higher debt-to-income ratio. Conventional institutions like banks tend to be more conservative in their debt-to-income ratio thresholds. The highest ratio that borrowers can have in order to get a qualified mortgage is 43%.
Does the debt-to-income ratio affect credit scores?
No. Your debt-to-income ratio is not something that is explicitly mentioned in credit reports. Even though the credit bureau may know what your debt-to-income ratio is, they do not use it to calculate your credit score.
Having a high or a low debt-to-income ratio by itself does not impact credit scores.
Credit scores are significantly impacted by the amount of credit that you utilize in relation to the total credit limit that you have been offered. So, if you happen to use reach somewhere close to your credit card limit regularly, then your credit score can get negatively impacted.
Selecting the right debt management plan as per the debt-to-income ratio
If you happen to have debt issues or simply want to pay off all your debt, then you know that there are multiple options out there. There are debt management programs, debt relief services, and DIY methods. Figuring out which route to take can be a bit confusing. One way to clear the confusion is to know your debt-to-income ratio.
If your ratio is below 15%, then you can probably use DIY methods like debt snowballing or debt avalanche and pay off the debt without any external help.
If your ratio is between 15% and 40%, then you might want to consider a debt management plan. This option works especially if your outstanding debt is mostly credit card debt. You will have to approach a non-profit credit counselor and get a better idea of how the debt management plan will work out in your case.
If your ratio is more than 40%, then you will have to look either at bankruptcy or a debt relief service. Other methods may not be feasible given the high debt repayment burden on your income.
Improving your debt-to-income ratio
The debt-to-income ratio depends on two main values – your gross income levels and your debt repayments. Therefore, you can alter your debt-to-income ratio in two ways.
Either, you can increase your gross monthly income or you can reduce your debt payments. The second option is generally more complicated to achieve.
The first one is within your control. You can either find a second job, take up a freelancing project, or figure out a way to earn some extra cash.
Are there different types of debt-to-income ratios?
Yes, there are two sub-types of debt-to-income ratios. There is the front-end ratio and the back-end ratio.
The front-end debt-to-equity ratio is the ratio calculated using the mortgage payments and other housing-related costs such as insurance premiums and property taxes. It estimates the proportion of your gross income that goes towards housing.
The back-end debt-to-equity ratio is the ratio that takes into account all the debt payments that are not related to housing. This includes credit card debt, student loan repayments, car loan repayments, and legal payments such as child support or alimony.
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