Owing a lot of money can affect your ability to pay the bills, live on a comfortable budget, and accomplish other financial goals. It can also make it hard to get approved for additional loans if you need to borrow again.
It's not just how much you owe that matters, though -- it's how much you owe relative to the amount you make. That's why your debt-to-income ratio is so important.
Your debt-to-income ratio, or DTI, is used by lenders to determine if you can afford to take on any more debt. If it is too high, you may be barred from getting a mortgage or personal loan. Your DTI can also be an indicator that you're in over your head with creditors and that it's time to get serious about paying down your debt.
Image source: Getty Images.
How is your debt-to-income ratio calculated?
Calculating your debt-to-income ratio is easy. Simply add up all of your monthly debt payments and then divide by your gross monthly income, which is income before taxes and deductions are taken out. So, for example, let's say you have a bunch of different debts:
- A $300-per-month car payment
- A $250-per-month student loan payment
- A $30-per-month minimum credit card payment
In this case, your total debt payments would be $580. If your gross monthly income was $3,200, your debt-to-income ratio would be calculated by dividing $580 by $3,200. Your DTI would equal about .18, so it would be about 18%.
Front-end and back-end debt-to-income ratios
One of the most common uses of a debt-to-income ratio is to determine if you can qualify for a mortgage. Mortgage lenders actually look at two different debt-to-income ratios: a front-end ratio, and a back-end ratio.
- Your front-end ratio looks only at the portion of income that's spent on housing payments, including mortgage principal and interest as well as property taxes and insurance.
- Your back-end ratio looks at all of your monthly debt payments, including mortgage costs and other debts.
So let's say you owed the same payments as above, and also wanted to buy a home that would have a $1,400 monthly payment including mortgage costs and monthly contributions toward property tax and homeowner's insurance payments.
In this case, you'd have to add $580 (your other debt) to $1,400 and divide this number by your $3,200 monthly income to figure out that your back-end ratio is about 62%. Your front-end ratio, which just looks at housing costs relative to income, would be $1,200 divided by $3,200 or about 38%.
How high is too high for your DTI ratio?
Typically, mortgage lenders want a 28% front-end ratio and a 36% back-end ratio. So with our above example, the borrower would probably be denied a mortgage loan because his or her front-end ratio and back-end ratio are both too high.
Some lenders allow you to purchase a home with a higher ratio of debt relative to income. In fact, mortgage lenders may even go up to 50% for the back-end ratio if a borrower is otherwise well-qualified with a good credit score and a reasonable down payment. But if you are taking on that much debt, you're likely going to be cash strapped and have a difficult time making your budget work, or accomplishing other financial goals such as saving for retirement.
How can you lower your debt-to-income ratio?
You have just two options for lowering your debt-to-income ratio:
- Paying off debt so your monthly payments are lower
- Increasing your income so your monthly gross income is higher
In some cases, you can also take steps to lower your payments without actually paying down a sizable chunk of debt. For example, if you owe a lot on student loans and your educational debt is preventing you from buying a house, you may decide to switch to an income-contingent or graduated repayment plan that would lower your required monthly payment.
Although this wouldn't actually help you make any progress on your debt, it would free up room in your monthly budget and make you a more attractive borrower. This could sometimes mean the difference between being able to buy a house or having to wait.
Understanding your DTI is important
Mortgage lenders aren't the only ones that consider debt relative to income when deciding if you should be allowed to borrow. Auto loan and personal loan lenders may also evaluate whether you have too much debt relative to income, and thus present too great of a credit risk.
You can also use your debt-to-income ratio to determine if debt payments are taking too big a chunk out of your budget. If more than 30% of your monthly income goes toward paying debt, you may want to take drastic steps to deal with this high ratio -- such as switching to a cheaper car to reduce your car loan costs.
Now that you know how DTI works, you can figure out your number and see both if you're likely to be considered a well-qualified borrower and if getting serious about paying down debt needs to be a top priority for you.
More From The Motley Fool
- 10 Best Stocks to Buy Today
- The $16,728 Social Security Bonus You Cannot Afford to Miss
- 20 of the Top Stocks to Buy (Including the Two Every Investor Should Own)
- What Is an ETF?
- 5 Recession-Proof Stocks
- How to Beat the Market
The Motley Fool has a disclosure policy.
This article was originally published on Fool.com