What is debt-to-income ratio and why is it important?

Are you thinking of buying a house sometime soon? Or how about refinancing your student loans? If you’re thinking of doing either, there’s a number you should know aside from the all-important credit score.

It’s your debt-to-income ratio, and it could get in the way of you being able to buy your first home, or refinance your student loans. How?

Your debt-to-income ratio is used in a variety of situations to determine your level of risk as a borrower. If your debt-to-income ratio is too high, your opportunities to make a big purchase (like getting approved for a mortgage) may be limited.

What is debt-to-income ratio?

Debt-to-income ratio, which is often abbreviated as DTI and refers to how much debt you have in comparison to your income. This is an important number for lenders because it can help determine your ability to pay back your debts.

Borrowers that have high debt-to-income ratios are often considered red flags to potential lenders. Lenders want to know that you will be able to sufficiently make payments on your debt with the current income you have. There are two types of debt-to-income ratios that lenders look at:

Front-end ratio, which shows how much of your income goes toward expenses.

Back-end ratio, which shows how much of your income goes toward expenses as well as your monthly debt obligations.

In order to calculate your back-end debt-to-income ratio, start by adding up your monthly debt payments plus housing costs and dividing it by your monthly gross income (before taxes and deductions).

Here’s an example of how you can calculate your back-end DTI.

Auto Loan: $250 monthly + Student Loan: $300 monthly + Housing: $1200 = Total: $1750

If your gross income is $3,000, you’ll take 1750 and divide it by 3,000, which would give you a 58 percent debt-to-income ratio — which is pretty high. Basically it means that 58 percent of your income is allocated towards debt payments. It’s important to keep your debt-to-income ratio low and work to eliminate debt altogether. If you are dealing with sky high student loan balances, or steep credit debt while only making a modest salary, you could look like a risk to prospective lenders.

This could limit your opportunities, and you may need to focus on paying off debt and increasing your income first, before applying for a mortgage.

Why is Debt-to-Income Ratio Important?

Your debt-to-income ratio is important to know because it’s used by lenders to assess your creditworthiness and to determine if you are a good candidate for things like a mortgage or student loan refinancing.

Debt-to-income ratio can often be overlooked — people think that if they have a good credit score and high income, they are set. But that’s not enough to be considered a good candidate for many lenders.

You can make a higher-than-average income, but if you have a high debt load as well, you may be in trouble. Conversely, you may not have that much in debt, but if you’re income is on the smaller side, your DTI can seem disproportionately larger. Consider the fact that lenders don’t know you and can’t look into the future to determine the likelihood that you will repay your loan — so they look at historical data, and verify your income and your current debt totals to make a postulation about your ability to make payments.

What is a Good Debt-to-Income Ratio?

Obviously, you want to keep your debt-to-income ratio as low as possible. This shows lenders that you have a good balance between debt and income, and are likely to be able to manage your payments.

A good debt-to-income ratio is typically below 36 percent. In most cases, having a debt-to-income ratio of 43 percent is the highest ratio you can have to be qualified for a mortgage.

This is important to know if you are planning to purchase a house soon and are saving for a down payment. In some cases, you may be rejected for a mortgage or refinancing opportunity because of your DTI.

What Should You Do?

If your debt-to-income ratio is high, work on paying back your consumer and educational debt. As time goes on, grow your income as well through negotiation and raises. Doing both of these things will help lower your debt-to-income ratio, so you become more attractive to lenders and have more opportunities available to you.

Source: Businessday