What Is Debt-to-Income Ratio and Why You Should Care

What Is Debt-to-Income Ratio and Why You Should Care

A little debt isn’t necessarily a bad thing. In fact, many rites of passage in life involve taking out loans — financing your first car, going to college, or purchasing your first home. But there’s a fine line between an “acceptable” amount of debt and too much debt. And once you cross that line, it might be hard to step back into safe financial territory.

Paying too much each month in expenses definitely puts a strain on your personal finances and wrecks your budget, if you have one. But your troubles are compounded because a high level of debt — especially on your credit cards — hurts you in a myriad of other ways, too. For example, when your burden of credit card debt grows past a certain point, it will start to have a negative effect on your credit score.

And as you know, once your credit score drops, doors begin to close on a whole world of credit.

So how do you know when you’ve crossed the line? What does an “acceptable” level of debt look like? Enter the “debt-to-income ratio”.

What is Debt-to-Income Ratio?

Your debt-to-income ratio is an important financial indicator about the health of your personal finances. Lenders look at this number when they consider you for loans. If it’s too high, it raises a red flag that you might have too many financial troubles to handle a loan right now.

That means every time you finance a major purchase — an automobile or a home come to mind — your DTI will play a major role in determining what kind of terms you get on that loan.

Pros in the industry will refer to it as “DTI”. Financial jargon aside, however, it’s actually a simple concept. Take the total of the debt payments you make each month and weigh that number against your monthly income. There’s your debt-to-income ratio.

Let’s drill down a bit on that…

How is the Debt-to-Income Ratio Calculated?

Let’s say you take in $4,000 as your gross monthly salary. But of course, not all of that hits your bank account (or stays there) because you have expenses to account for, many of which are debt payments.

So let’s also say that you’re spending $2,700 of that on debt payments alone. That puts your DTI at a very dismal 68 percent. Good luck getting a mortgage with that number. It’s nearly double what’s considered to be a healthy percentage: 36 percent or less.
And good luck maintaining a respectable credit score with that number, too. More on that later but let’s take a look at another way your debt-to-income ratio can be calculated.

Another Way to Calculate Debt-to-Income Ratio

There are two ways to look at your debt-to-income ratio. The formula described just above is for calculating the “back-end” DTI. Here’s how to calculate the “front-end” debt-to-income ratio: add up your monthly housing costs and divide that number by your monthly gross income.

Renters have a simple calculation to make but homeowners must take into account property taxes, mortgage principal, home insurance, and mortgage interest. And if you live in a condo or any other type of home where you have to pay a homeowner’s association fee every month, that amount will have to be added in, too. Paying a lot each month for your home, when it’s not balanced with a high monthly income, can lead to a poor debt-to-income ratio.

Borrowing Affects Your DTI AND Your Credit Score

So the more you borrow, the more you’re tipping the balance of your DTI ratio upwards. And as we’ve just learned, reaching the tipping point will put you at a serious disadvantage when it comes time to apply for loans.

But there are other reasons to keep your borrowing to a limit, other than maintaining a good debt-to-income ratio. One of them is an equally important number: your credit score. Like the debt-to-income ratio, it’s an indicator of your financial well-being. And, also like your DTI, your credit score can be impacted in a negative way when you borrow more money.

Experian, Equifax, Transunion use both your DTI and your credit score to determine whether you meet their qualifications for getting a loan. Anything that lowers your either of these all-important personal financial numbers is something you should definitely try and avoid.

A prime example of this is applying for loans that require a “hard credit check”. Each time you apply, your file gets pinged with a hard credit check, and the big credit bureaus mentioned above make a record of it. Too many pings and the result is a drop in your credit score. That, along with any added financial problems you encounter on the road ahead, can result in a sort of debt spiral that can impact your life for years. It’s much better to try and keep your debt-to-income and credit score numbers at reasonably acceptable levels.

How to Keep a Healthy DTI and a Good Credit Score

So how do you keep your financial performance indicators up in the healthy zone when emergencies happen? Without an emergency fund to draw from and little in the way of savings, there aren’t a lot of good options.

One way to avoid the hard credit check but still cover an emergency is a personal loan. Unlike many other loans, there’s no hard credit check involved. You maintain your credit score and you cover your bill. Then, when the loan is paid off quickly (as payday loans typically are), you maintain your DTI as well.

What Kind of Debt-to-Income Ratio are Lenders Looking For?

Lenders vary in what they find acceptable but in general the 36 percent back-end ratio mentioned earlier is the gold standard. For front-end ratios, lenders want to see 28 percent. Certain types of lenders, like those who deal in FHA mortgages, can work with a DTI as high as 50 percent. But that doesn’t mean you’ll get a good, low interest rate. Ask any credit counsellor: you’ll need a lower debt-to-income ratio combined with a good credit score to get the most favorable interest rates. And in the end, that will save you money when it comes time to make the biggest milestone purchase of all: your home.