Debt to income ratio (DTI) number is probably as important as your credit score. Lenders use this ratio along with credit score and other important factors to figure interest rates and loan amounts. This means that to qualify for the best mortgage or car loan terms you must have an ideal ratio at the time of credit application.
Aside from the above benefit debt to income ratio is also important for managing your money. By knowing your own ratio you can get an exact picture of your financial situation. And if you control the ratio in the safe range you’ll be sure that you can get a home or a car without facing serious debt problems.
What is Debt to Income Ratio?
Your debt to income ratio is a ratio between your monthly gross income and the amount of debt you have to pay every month. Lenders use this number to look at your ability to pay off your mortgage payment after you meet all other obligations.
This ratio is usually written in the following format: 30/38. Those numbers refer to “front ratio” and “back ratio”.
You can calculate your front ratio by adding up your monthly principal, interest, taxes and insurance and then dividing it with your monthly gross income. And by adding up consumer debt such as car loan payment, credit card debt and other related expenses to the previous calculation you can get your back ratio.
Calculate Your Debt to Income Ratio
To find your debt-to-income ratio add up all monthly recurring debt that include mortgage and equity loan, car loans, student loans, minimum required payments on credit card debt and divide it by your monthly gross income.
Let’s say you earn $65,000 per year or $5,416 per month. Your total mortgage payment is $1,150, car loans are $285, and your minimum credit card payments are $180. That equals a recurring debt of $1,616 a month. By dividing the $1,616 by $5,416 you’ll find your DTI ratio is 29.84 percent.
For the purpose of credit application analysis different lenders might use different DTI ratio reference to decide how much they’re willing to lend you.
For example, if your lender’s front ratio reference is 28 it means that you’re only allowed to use 0.28 x $5,416 or 1,516 for housing expense. And if the lender’s guideline for back ratio is 36 you’re only allowed to spend 0.36 x $5,416 or $1,950 for housing expense plus recurring debt.
Improve Your Debt to Income Ratio
If you plan to get a significant amount of loan in the near future and your DTI ratio is above your lender reference, take steps to reduce the ratio before you apply for the loan. You can improve your ratio by increasing income, reducing expenses or both.
Finding another source of income is a good idea. You don’t need to change your lifestyle or spending habits to get a higher DTI ratio. This can be a part time work at night or during weekend if you can set aside the required time for the temporary job.
You may also want to check your monthly budget to understand where your money goes and where you can cut back. For example, you may want to cut back major purchases related to entertainment and use the money to double your monthly credit card debt payments instead. Alternatively, you may want to pay more on any loan as long as it can reduce your debt.
With those steps not only will you be able to control your money to achieve a favorable debt to income ratio but you also learn to improve your financial situation by acquiring things that will actually make you more money than you spent on them.