Knowing your debt-to-income ratio is important to understand how it can affect your credit score and credit approvals.
Your debt-to-income ratio (DTI) is more than just a number. As a key indicator of your overall financial health, it could mean the difference between getting approved or turned down for a mortgage loan on your dream home. Mortgage lenders in particular rely on the DTI calculation to determine how much mortgage debt a potential borrower can handle based on his or her income. Your DTI also affects your credit score and may play a role in determining whether you’re approved or denied for other types of credit. Knowing where your ratio stands can help you evaluate whether your monthly debt payments are out of sync with your income. With that knowledge in hand, you can determine the likely outcome of any new credit application, whether you’re looking to open a new credit card or finance a new furniture purchase.
A debt-to-income ratio of less than 36 (the lower the better) generally indicates that the money you have coming in can realistically cover the minimum debt payments you must make each month. A higher score, on the other hand, could mean that you’re skating on thin financial ice.
Crunching the numbers
To understand what your debt-to-income ratio is and what it means, you need to know the components that go into calculating it. The ratio itself represents the percentage of your monthly income that must go toward making “minimum” debt payments each month. There are two types of DTI: front-end and back-end. The front-end number includes all the monthly expenses associated with your housing expenses – such as mortgage payment, taxes, and insurance. The back-end number is more comprehensive because it factors in additional debt payments such as credit cards, auto loans, and student loans. In a Bankrate.com article, “Why Debt to Income Matters in Mortgages” by Polyana da Costa, source Matt Hackett, who is an underwriting manager of Equity Now, says that the back-end number is what most lenders focus on for conventional home loans.
How to Calculate Your Back-End Debt-to-Income Ratio
First, add up the total minimum payments* you have to make each month (don’t include non-debt payments that you may include in your monthly budget, like groceries, entertainment, or utilities):
- Housing expenses – mortgage payment, insurance and taxes
- Car payment(s)
- Student loan payment(s)
- Credit card payment(s)
- Other loan payments
*Total payments for your calculation should include only the minimums you’re required to pay each month to keep your accounts current. Extra amounts you pay above the minimum should not be counted. Next, divide your total minimum monthly payment figure by your gross monthly income. Here’s an example of how the calculation might look:
$1,000 (mortgage, home insurance, and taxes)
+ $250 (car)
+ $50 (credit card)
= $1300 (total)
Gross monthly income = $3,500
$1,300/$3,500 = 37% DTI
And that’s how it’s done. Now you can calculate your back-end debt-to-income ratio on your own and use it to evaluate your current financial situation. You may find that you’re in a great position to move forward with your plans to buy a larger home or make a major purchase. Or, you may decide that your debt load needs to be pared down. Either way, your debt-to-income ratio can be a useful piece of information to have on hand when it comes to managing your finances. Since you now understand how this formula works and how it factors into your personal finances, you can use our debt-to-income calculator to help you; all you have to do is plug in the numbers. [calc id=1205]