What is Debt-To-Income Ratio?

Debt-to-income ratio is one of those terms the average person never heard about before until the time comes to take out a loan.

In particular, concerns over a debt-to-income ratio can create problems for a borrower interested in an approval or even just a decent APR on a mortgage, personal loan, or credit card.

Understanding what the ratio represents isn’t too difficult. Neither may be addressing any troubles a high debt-to-income ratio might cause.

The process all starts with defining what the term means.

What is Debt-To-Income Ratio?

Debt-to-income ratio doesn’t refer to anything more complex than what its name infers.

When you take out a loan, you incur debt.

Even when you aren’t in arrears, debt has an effect on your overall financial situation.

You do need to pay a debt back. Debt payments come from your income.

If you earn $3,000 per month and your you pay $1,500 on a mortgage, $150 in monthly car loan obligations, and another $350 in credit card and personal loan payments, then your debt-to-income ratio is 66%.

$2,000 is 66% of $3,000

So, a debt-to-income definition refers to the percentage derived from subtracting obligations from monthly income.

Actually, you could devise a DTI ratio based on quarterly, bi-monthly, and annual income as well.

The $2,000 vs. $3,000 figure comes out to $24,000 in debt payment per year for someone earning $36,000 in annual salary.

That’s still a debt-to-income ratio of 66%.

Most people prefer to track their budget monthly. So, it becomes preferable to use a monthly DTI formula.

And it goes without saying a 66% DTI ratio isn’t optimal no matter what time period is used for the formula.

An excessive debt-to-income ratio means little money ends up being left over for other expenses. Finances become incredibly stretched as a result.

That’s why you want to bring a DTI ratio down to a reasonable figure.

Please be aware the income factored into the debt-to-income ratio is gross income. That means you use the pre-tax figure as opposed to an after-tax one.

A combination of high debts and common taxes may leave you with little cash flow during the month. This can be troubling to say the least.

Two Main Types of Debt-To-Income Ratio

While relatively simple in concept, a debt-to-income ratio can take on two different forms. Understanding the difference between the two allows for better planning.

After reviewing the stats, you might be able to devise a strategy to lower your debt-to-income ratio. You might even be able to get the percentage down to financially controllable territory.

The two different types of debt-to-income ratio are:

• Front-end Ratio

• Back-end Ratio

Front-end Ratio: This ratio refers to all the expenses related to the costs of housing. A front-end debt-to-income ratio takes into consideration all costs related to mortgage, homeowner’s insurance, and the like. Debts not related to housing do not factor into the front-end ratio.

Back-end Ratio: The back-end ratio simply serves as another way of defining a full debt-to-income ratio. All debts including housing factor into coming up with the back-end debt to income ratio.

Creating two different ratios for review helps. Comparing the front-end ratio to the back-end ratio delivers clear comparison stats capable of helping someone improve a debt situation.

Based on reviewing the figures, someone may choose to refinance a mortgage. Refinancing could reduce the monthly premium leading to an increase in cash flow. A lower mortgage APR could also help with paying down the debt.

Refinancing a mortgage might be a little more difficult for some than taking steps to address other debt.

Completely paying off a credit card balance cuts out the monthly minimum payment requirement.

Once that payment is gone, the back-end ratio improves. After all, there’s more income and less debt obligation.

The process of taking any action usually starts with figuring out your debt situation. Reviewing the ratios helps with this cause.

How to Calculate Your Debt-to-Income Ratio?

Someone tells you that your debt-to-income ratio is 66%. Fine, but how did he/she arrive at the figure?

The person used a simple debt to income ratio formula.

In truth, the way to calculate debt to income ratio isn’t all that difficult. Simple math is all you need.

Here’s a look at the simple formula. We’ll use the original figures of $3,000 in monthly income and the $2,000 monthly debt figure to see how we came up with 66%.

When coming up with a back-end ratio figure, all monthly debt would be added up and divided by gross monthly income and multiplied by 100.

($2,000 / $3,000) x 100 = 66.6%

To come up with the front-end figure, only use the $1,500 monthly mortgage expense amount.

($1,500 / $3,000) x 100 = 50%

Again, the way to figure out either ratio isn’t all that difficult. However, you doubtfully want to make any mistakes that create an inaccurate result.

Figuring things out “long hand” might not be the preferable way to avoid errors.

Another option exists. Just take advantage of an available debt-to income-ratio calculator.

Such a calculator employs a simple program designed to figure out the ratio automatically. All you need to do is type in the appropriate numerical figures in the designated areas.

Don’t worry about spending any money on a decent debt-to-income calculator. Scores of free ones can be accessed online. Unfortunately, an online calculator comes with a user-friendly layout. So, you may need to look at a few different ones to find the right calculator for you. This shouldn’t take too long.

Debt-To-Income Ratio Calculator for Personal Loans

Personal loans are unsecured debt. Any loan you take out that does not require collateral or isn’t used to finance a car, boat, home, or other property falls under the category of unsecured.

Personal loans, lines of credit, and credit card borrowing are all forms of unsecured debt.

They are unsecured because your income and credit history “speak” for your ability to pay back the loan. The lending management checks the transactions you have made in last couple of years and based on the money you have played with, you’ll get a personal loan.

Additionally, these personal history items play a part in determining the terms of a loan.

Someone with weak credit may be forced to pay a high rate of interest.

Personal loan lenders positively do look at debt-to-income and balance-to-credit ratios when reviewing applications.

Don’t make the mistake of believing paying debts on time is the only thing factoring into your credit score.

Your current level of debt also contributes, in part, to the overall score.

That’s why you should use a credit ratio calculator to figure out your debt-to-income percentage. Once you know what it the percentage is, you can determine if the ratio is working against you.

A credit ratio examines how much credit you utilized vs. the amount remaining.

Here’s an example of how this is figured out:

A person has $10,000 in available credit and takes out $7,500 in borrowed funds.

This means he/she has a credit ratio of 75%.

75% would generate a disastrous impact on a credit score.

A person with that high of a credit utilization ratio comes off as being unable to control his/her finances.

A person with that level debt flat-out borrows too much and, possibly, lacks the means to pay back his/her obligations.

A credit ratio calculator can deliver an accurate figure for those wondering what the actual ratio is. The calculators usually employ a simple program design. You would type in the various balances of the credit cards and other loans you hold.

Then, you would type in the credit limits for the numerous cards. The calculator then figures out the credit ratio automatically based on the provided figures.

Debt-to-Income Ratio Calculator for Mortgage Approval

Taking out a mortgage means more than just buying a home to serve as a residence. Acquiring a home through a mortgage sets the stage for establishing significant net worth.

Homeowners generally draw the bulk of their net worth from the value of their property.

If the value of the home rises beyond what was paid for it, everything works out as near-perfect as possible. You made a profit on the home.

Most people can’t pay cash for a home. So, in order to move this process in motion, you must be approved for the mortgage first.

Read: 5 Benefits of Buying a Home

A decent debt-to-income ratio factors heavily into how well the banks look at your application.

Running your current financial situation through a calculator that displays your debt-to-income ratio prior to filling out a mortgage application could answer some general questions.

While the figures revealed by the calculator won’t tell you for certain if you will be approved or denied for a mortgage, you can get an idea what your chances are.

If the ratio turns out to be a positive one, chances likely appear to be better.

What is a Healthy Debt-To-Income Ratio?

A healthy debt-to-income ratio can be best described as one that proves beneficial.

A debt-to-income ratio should be a positive in the eyes of lenders. To the would-be borrower, the figures presented on a debt-to-income ratio calculator might not mean much.

Is there really much of a difference between a 40% ratio and a 50% one?

In the eyes of lenders, yes, there is.

A wise question to ask would be “What is a good debt-to-income ratio?”

You do want to strive for the best possible ratio.

Generally, anything under 35% would work in your favor. And it would work in your favor merely assisting with a mortgage approval.

Maintaining a healthy debt-to-income ratio means more than just being a solid applicant for a loan. It is also about living a life that doesn’t come with tremendous financial stress.

When you owe significant sums of money and your income level isn’t high enough to cover the costs associated with the debt, life becomes strained.

Most people can barely cover other essentials such as food, utilities, and car expenses when a debt-to-income ratio becomes excessive. For that reason alone, consider it wise to work on paying down debt as quickly as possible.

And then there’s the matter of accessing the best debt-to-income ratio mortgage offer. Just as mortgage lenders want to approve the best applicants, applicants want to accept the best loan offers. A solid DTI helps both.

Importance of 43% Debt-To-Income Ratio For Mortgages

One figure that stands out when discussing the issue of decent debt-to-income ratios is the magic number of 43%.

The number holds special significance for those interested in acquiring a mortgage. Many consider 43% to be the ideal debt-to-income ratio for mortgages. The reasoning isn’t arbitrary.

Mortgage lenders do not want to foreclose on properties. They would prefer seamless loan arrangements in which the borrower pays back the loan in a timely manner and without any troubles.

This is where the DTI ratio mortgage loan review process comes into effect. The lender looks at the applicant’s application to determine the debt-to-income ratio.

43% becomes a critical figure because this is the cutoff number for a qualified mortgage.

Smaller lenders may be willing to offer a qualified mortgage to someone with a ratio higher than 43%, but they would be the only ones.

What is a qualified mortgage?

A qualified mortgage loan refers to one issued without a number of riskier features. Lenders who issue qualified mortgages usually take steps to make sure the borrower legitimately has the ability to repay.

In short, a qualified mortgage maintains many benefits over a potentially costlier subprime mortgage.

What is a Good Debt-to-Income Ratio for Buying a House?

Clearly, you would not want the ratio to rise up beyond 43%. However, don’t lose sight of the fact of 43% reflects the absolute highest threshold for quality mortgages.

A target goal should be a much lower debt to income ratio. Using a debt-to-income worksheet might help with figuring out how to reach this target goal.

Generally, the 28/36 rule is best to follow.

Bringing the ratio down to 28% might be the most preferable figure to achieve.

Doing so, however, won’t exactly be easy. That said, cutting out debt and boosting income isn’t exactly a bad plan regardless of the effort required.

The plan still must be done with a reasonable outcome in mind though.

Taking the number into the 30-percentile range probably would be more logical and realistic.

Aiming for 36% might be the best course of action.

Reaching such a figure does depend upon your current debt-to-income ratio. If the ratio is very high, then it will take a lot of work to bring it down.

Perhaps taking a second job may be necessary to increase income and pay down debt. Yes, this means a lot more work and effort. The reasons behind taking on the extra work should make everything worth it.