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Debt-To-Income Ratio – Understanding the Basics
Debt-to-income ratio plays an important part in a lender’s decision to grant credit. Learn how to calculate your own DTI before applying for a loan.
Defining Debt-To-Income Ratio
A ratio is basically a percentage. If, for example, there are 10 eggs and 2 of them are brown, the ratio of brown to white is 2:8. Expressed as a fraction, one would say that 2/10 of the eggs are brown. Translating that to percentage, one would say that 20% of the eggs are brown and 80% of the eggs are white. When calculating debt to income ratio, the goal is to determine what percentage of total gross monthly income is spent on debt. It important to note that the income calculation is one’s gross, that is, before taxes and other deductions. Debt for purposes of this particular ratio refers to all of the recurring monthly debt that appears on one’s credit report. Therefore, mortgage payments, car loans, personal loans, student loans, and credit card debt are all considered as a part of the debt. Taxes and insurance paid on a home are also considered. If there is no mortgage, the amount paid in monthly rent is added into the debt. It is also important to note that monthly expenses such as groceries, gas, utility bills, and personal/entertainment items are not included when calculating debt-to-income ratio. For example, if an individual’s gross monthly income is $2000, and the total of all included monthly debt is $800, the debt-to-income ratio is 800:2000, or 8/20, or 40%.
Acceptable Debt-To-Income Ratio
When creditors are considering an individual or a couple for a loan, and especially when that loan is for a mortgage, the debt-to-income ratio is extremely important. Generally, potential lenders do not like to see a ratio of more than 50, or 50% of the total gross monthly household income. So, a lender will look at the monthly debt appearing on the credit report, subtract any old mortgage that is to be paid off with the new mortgage loan, or rent payments that will stop with a home purchase, and add the new mortgage loan, taxes and insurance amount. They will then figure the total ratio by dividing the income into the total debt. If the result is 50% or less, the lender is happy. The basic guideline is that debt should be 50% or less of total gross monthly income, in order for a debtor to be comfortable with making all payments due each month.
If the debt-to-income ratio exceeds 50%, the lender will either deny the loan or request additional information/proof that the potential debtor will be able to meet all of his/her monthly obligations should this additional loan be approved.