Steadfast FinancesYour Debt to Income Ratio - What You Need to Know about it

What You Need to Know about Your Debt to Income Ratio

Filed in Banking , Debt Reduction 3 comments

Have you ever heard of the term debt to income ratio? Although this term may not be as popular as the credit score, this is also something that lenders like to look at when evaluating their borrowers. This figure is important because it represents the cash flow of an individual.

When the debt to income ratio is calculated, lenders can have an idea of just how much of the borrower’s income is going towards paying off his debts. Knowing this ratio will help lenders calculate the risk of giving a loan to that particular individual.

So, if you are planning to get a mortgage, it’s important for you to know what your debt to income ratio is so you can self-assess how well you qualify.

What Does The Ratio Mean?

In simple terms, the debt to income ratio is the percentage of your income which you use to pay off your debts.

Most banks agree that a healthy debt to income ration should be less than 36% of your gross income.

If your ratio is low, then banks perceive you as having a higher percentage of being able to pay off your debt, on the other hand, if you have a higher ratio, then the more of a credit risk you become. If your ration is higher than 36%, then you may have a difficult time finding affordable credit.

Two Kinds of Debt To Income Ratios

There are actually two kinds of DTIs, the front end and the back end. Knowing about these two kinds of ratios will help you calculate your debt to income ratio.

Front End Debt To Income Ratio

The front end ratio can be more associated with how much you would pay for housing. This isn’t exclusive only for those who own homes, but it can also apply to renters. If you are a renter, then the front end ratio is how much of your income goes towards paying your rent, while for home owners, it’s how much of your income goes towards paying off your mortgage, and a few other housing expenses like property taxes, insurance, and association fees.

Back End Debt To Income Ratio

The back end ratio on the other hand, is associated with all the other debts that you have aside from housing. These debts include credit card payments, car loans, student loans, child support, and other fixed expenses which you can’t just cancel.

Calculating Your Debt To Income Ratio

Since establishing your debt to income ratio is important for lenders, then it should be vital for you to know where you stand. This can be done by simple calculations which you can easily do at home.

The DTI can be calculated by using this equation: x/y, where x is the front end DTI and y is the back end DTI.

Most lenders will need you to have a DTI of about 28/36, although this is not the fixed ratio. In any case, here’s what you need to do to calculate your DTI.

  1. Know your monthly income – If your monthly income changes, then you just take your yearly gross income and divide it by 12. For example, your yearly income is $45,000 per year. $45,000 / 12 = $3,750.
  1. Know your front end ratio – Take your monthly income and multiply it by the first number in the DTI requirement of the lender. In this example, it is .28. So, 3,750 x .28 = 1,050. This is the amount of your monthly gross income which is allowed for your housing expense.
  1. Know your back end ratio – This time multiply your monthly income by the second number of the DTI requirement. Here, it is .36. So, 3,750 x .36 = 1,350. This is the amount allowed for both housing expenses and recurring debts.

The DTIs of most lenders only allow a small amount for recurring debt payments. In this case, it is only $300 for your other loans like car loans, student loans and credit cards.

Improving Your Debt To Income Ratio

If you find that your DTI is not satisfactory, then you can take measures to improve it. You can first opt to increase your income, or you can also reduce your debts. If you are still interested in qualifying for a mortgage, then it is important that you take measures to avoid recurring payments on other kinds of debt.

Again, the debt to income ratio is something to really take notice of because it is an indicator of your monthly cash flow. This gives lenders an idea of how much allowance you will have to pay off your monthly financial obligations without getting into a cash crunch in cases of emergencies. Always remember that the lower your debt to income ratio is, the better your cash flow. The higher the likelihood that you can pay off your loans.

Have you recently applied for a loan? How did it go?

Author Bio: YFS is owner and author of Your Finances Simplified. He was born and raised in West Philadelphia and is now a financial adviser, IT contractor, landlord, and treasurer of a non-profit. He created his blog partly due to his desire to help people with their finances.

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Posted by Dominique Brown   @   27 February 2012 3 comments
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3 Comments

Comments
Feb 27, 2012
12:23 pm

Good examples of how to calculate DTI. Unfortunately, I don’t think many people consider this figure until they find out it is too high to quality for the loan they are trying to get. Out of curiosity, if someone already has a primary mortgage and is trying to qualify for a second one (for say a rental property), is there a rule of thumb figure they can try to shoot for? Would this second mortgage be considered back end?

Feb 27, 2012
5:41 pm
#2 Usiere :

Good post. You need to know your numbers, and keep focused and driving it in the right direction. Financial education is crucial. Ultimately you want to get out of debt completely and borrow to finance assets only

Mar 1, 2012
10:39 pm
#3 YFS :

@ Mymoneydesign,

The primary mortgage would be your backend and the second mortage would become the front end when trying to qualify for the new loan. They work in tandem so it all counts.

@ Usiere,

Thank you and I will try to keep going in the right direction. I must admit sometimes it’s hard not acting reckless

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