What is a debt-to-income ratio? Why is it important?
September 11, 2017
You are a realistic person; you have lots of plans for your Business, Child’s future education and many more. To make sure that you meet all your expectations you have decided to opt for Loan. When decided to opt for loan you’ve probably come across this concept “Debt-to-Income ratio”
Banking or any other Non Banking firms they will first check “Debt – to- Income Ratio”. What exactly is this? Let’s have a look on it and why it is so important.
What is “Debt- to- Income ratio”?
Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the payments you make every month.
Your debt-to-income value tells a potential lender about your ability to manage monthly expenses and repay loans, or even mortgages.
A low debt-to- income value shows that you’re capable of managing your funds well. These are things that will help a lender trust you, making them more likely to grant you the loan you need.
Debt-to-Income Calculation Example
If you make $4,000/month, before taxes, this is your gross monthly income. Let's assume that you have a car payment of $400/month and a house payment of $1,200/month, and a monthly minimum payment on your credit cards of $250/month. The total of these monthly expenses is $1,850.
To establish your debt-to-income ratio, divide your monthly debt payment by your monthly income. The end result is your debt-to-income ratio.
- Monthly income: $4,000
- Monthly debt payment: $1,850
- Debt-to-income ratio: $1,850/$4,000 = 46%
Now that you know your debt-to-income ratio, it’s time to discover what your ratio is telling you. If you have a ratio of 30% or less, it means you have a great debt-to-income ratio, meaning your income is significantly more than what you owe. However, if you have a debt-to-income ratio of 44% or higher, it means you are taking on too much debt in relation to your income.
It’s important to keep your debt-to-income ratio low and work to eliminate debt altogether, if your debt-to –income ratio is high you could look like a risk to prospective for lenders.
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?
Keep your debt-to-income ratio as low as possible will help you getting loan as lenders will have a perspective that you can manage your income and repay loan.
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.
What should I do to have a balanced debt –to- income ratio?
If your debt-to-income ratio is high, work on paying back all your debt. As time goes on, grow your income as well through negotiation and raises. Doing both of these things will help you lower your debt-to-income ratio, so you become more attractive to lenders and have more opportunities available to you.