Measuring Your Financial Standing with the Debt to Income Ratio

By on | General Debt & Loan Consolidation Information.

Before settling on a residence and signing along the dotted line, prospective homeowners must ask themselves the critical question- how much home they can afford. This, of course, is a function of their financial stability and creditworthiness, two leading factors gauged by a widely-used formula known as the debt-to-income ratio (DTI). Lenders assess a consumer’s financial health by determining the amount of income available once all debts have been aggregated. The debt to income measure involves comparing a borrower’s income to the total amount of debt owed to creditors. By monitoring their debt-to-income ratio, individuals can 1)avoid escalating consumer debtand significant credit problems, 2) view the positive impact on their personal finances of paying more than the minimum on their credit card bills, and 3) make judicious decisions about taking out loans and purchasing on credit. The DTI concept is employed in the context of mortgage affordability, thus assuming added importance when consumers are trying to obtain home financing. Lending institutions evaluate a prospective borrower’s credit status by examining his or her debt to income ratio. Some of the consequences of a high DTI include: 1) inability to benefit from favorable credit terms and the lowest rates of interest due to the fact that such borrowers are at a higher risk of defaulting or being delinquent on their loans, 2) difficulty to acquire additional credit in the event of an emergency, and 3) threatened ability to purchase big-ticket items when desired. By maintaining a low DTI, consumers will increase their chance of eligibility for optimal loan terms and interest rates when applying for consumer credit.

The debt-to-income ratio may be calculated via one of two methods depending on which debts are included in the computation:

Front ratio

This represents the portion of gross income that is applied towards housing costs. The front ratio for renters is calculated by dividing the rent by the income. Homeowners obtain this figure by dividing PITI- the principal, interest, taxes, and insurance- by income. By figuring out the DTI, borrowers will know how much money is available to pay off the mortgage each month. Under this method, the debt-to-income ratio is calculated by dividing the total monthly debt payments by the borrower’s gross monthly income. The first step consists in adding up the income from all sources. For credit purposes, DTI is always calculated using gross income, which means income before deductions and taxes. Gross income includes the following:

regular salary government benefits income from child support and alimony Income from interest and dividends overtime and bonuses commissions tips, and other yearly income

After adding up the above-mentioned figures, consumers should divide the number by 12 in order to arrive at the monthly gross income. To determine the amount they can afford to pay monthly on their mortgage, borrowers should multiply their monthly gross income by 0.28.

Back ratio

This represents the portion of gross income that is allocated to payment of recurring debt each month. Rotating or revolving charges include the following:

Minimum monthly payment on all loans and credit purchases (This includes payments on credit cards, student loan payments, credit union/bank loans, installment payments on appliances and furniture, car payments, home equity line of credit, or other loans) Payments for medical care Child support payments Alimony payments Rent or monthly mortgage payment

Borrowers should add up all of these debt payments and exclude monthly expenses such as utilities, entertainment and groceries.

In general, a lower DTI translates into greater financial security, and the closer to 0% the borrower is, the more likely he or she will achieve a debt-free existence. Conventional lenders usually prefer that payments on mortgages not exceed 28% of borrowers’ monthly gross income and that the total debt expenses- including student loan payments, credit card bills, mortgage payment, and other debts- be equal or less than 36% of their income. This is referred to as the 28/36 eligibility ratio. Therefore, a debt-to-income ratio of 36% or less is deemed good and survives the eligibility test. While some creditors approve loans for individuals with a DTI in the range of 37-40% or higher, these borrowers may face difficulty in paying their bills. Consumers in the 40% or higher bracket should consider seeking out debt help since their credit situation is in the red. On the other hand, flexibility in relation to the debt-to-income ratio is prevalent among subprime lenders, who typically issue bad credit mortgage loans to applicants with a DTI in the 45-55% range. In exchange for liberal eligibility, bad credit borrowers generally pay a higher interest rate. While debt-to-income ratios are guidelines, they are not bright line rules. When it comes to loan approval, creditors have a lot of leeway and tend to conduct a global evaluation of their candidates by taking into account their personal situations and reviewing their entire application. After all, circumstances such as spending habits, emergency expenses, and number of dependents influence the amount of debt that borrowers can expect to handle.