Understanding your Debt to Income Ratio

You may heard the term debt to income ratio before but you may not have known how important it can be to your financial life, especially in terms of your credit and how much money you are able to borrow for big purchases such as homes and automobiles.

Your debt to income ratio, often expressed as DTI, is calculated by dividing your monthly minimum debt payments by your monthly gross income. Your mortgage or rent, utilities, food and entertainment expenses are not included in your monthly debt payments. So, for example; if you have a monthly gross income of $2000 and you have $700 in debt (consisting of credit card and loan payments) then you would have a debt to income ratio of 35%.

This formula does tend to vary somewhat from one lender to the next; but this is the general formula that is most commonly used. Some differences that might vary from one lender to the next would be the inclusion of a mortgage payment.

So, what is a good debt to income ratio and when do you need to worry? Ideally, your debt to income ratio should be 10% or less. Anytime your debt to income ratio is 20% or higher, this could spell trouble. Lenders recognize that any unexpected event could cause big financial problems when your debt to income ratio is this high.

That’s not to say that you won’t be able to be approved for a loan at all if your debt to income ratio is higher than 10%, but the higher your DTI is, the less likely you will be to qualify for low interest rates. And, of course, the higher your interest rates are; the more money you will spend on loans and the longer it will take for you to pay them off.

Furthermore, the higher your debt to income ratio is, the more it’s likely to lower your credit score; which can have a tremendous impact on whether you are able to be approved for certain loans as well as other aspects of your life. Many insurance companies are now refusing to insure individuals who have a low credit score because of the significant risk they pose. In addition, it’s quite possible that your credit score could cost you a job. More and more employers are now basing hiring decisions to some degree on applicants’ credit scores. The belief is that an employee with a low credit score, and therefore with financial problems, is much more likely to embezzle company funds, if in a position to do so.

 
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