Home » Financial Literacy » How to Calculate Debt-To-Income Ratio Show
Meet John, a supermarket manager who is married with three school-age children and takes home a comfortable paycheck. Sure, he has some credit card debts and a couple of car loans, but he never misses a payment and assumes that getting a mortgage for a new home should be a piece of cake. Then comes the bad news. After visiting several banks with a fat folder of financial documents, John is told he’s above the 43% Rule and his loan application is turned down. What’s the 43% Rule?The 43% rule is a ratio of debt-to-income, and a crucial standard for deciding who qualifies for a loan and who doesn’t. In reviewing loan applications, lenders compute the ratio of a person’s debt relative to income. The standard for qualifying for a home loan is 43 percent for loans through the Federal Housing Authority and VA. Conventional home loans prefer the DTI be closer to 36% to insure you can afford the payments, but the truth is that qualifying standards vary from lender-to=lender. If monthly debt payments exceed 43 percent of calculated income, the person is unlikely to qualify, even if he or she pays all bills on time. At the urging of lenders, the Consumer Financial Protection Bureau asked Congress in early 2020 to remove the 43% standard as a qualifying factor in mortgage underwriting. For other types of loans – debt consolidation loans, for example — a ratio needs to fall in a maximum range of 36 to 49 percent. Above that, qualifying for a loan is unlikely. The debt-to-income ratio surprises many loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines if they’ll be able to find a lender. What Is a Debt-to-Income Ratio?Debt-to-income ratio (DTI) is the amount of your total monthly debt payments divided by how much money you make a month. It allows lenders to determine the likelihood that you can afford to repay a loan. For instance, if you pay $2,000 a month for a mortgage, $300 a month for an auto loan and $700 a month for your credit card balance, you have a total monthly debt of $3,000. If your gross monthly income is $7,000, you divide that into the debt ($3,000 /$7,000), and your debt-to-income ratio is 42.8%. Most lenders would like your debt-to-income ratio to be under 36%. However, you can receive a “qualified” mortgage (one that meets certain borrower and lender standards) with a debt-to-income ratio as high as 43%. The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20). Put another way, the ratio is a percentage of your income that is pre-promised to debt payments. If your ratio is 40%, that means you have pre-promised 40% of your future income to pay debts. What Is a Good Debt-to-Income Ratio?There is not a one-size-fits-all answer when it comes to what constitutes a healthy debt-to-income ratio. Rather, it depends on a multitude of factors, including your lifestyle, goals, income level, job stability, and tolerance for financial risk. But there are general rules of thumb to follow when determining whether your ratio is good or bad:
Calculate Your Debt-to-Income Ratio in 4 Easy StepsSo the trick for many would-be-borrowers is a budget before they go shopping for a loan. Lowering a debt-to-income ratio can be the difference between a dream fulfilled and rejection. Calculating your debt-to-income ratio in easy 4 steps: DTI Formula
Monthly Debt Payments That Are Included in the DTI Formula:
Income Included in Your Monthly Income When Calculating DTI
Monthly Payments Not Included in the Debt-to-Income FormulaMany recurring monthly bills should not be included in calculating your debt-to-income ratio because they represent fees for services and not accrued debt. These typically include routine household expenses such as:
Front End and Back End RatiosLenders often divide the information that comprises a debt-to-income ratio into separate categories called front-end ratio and back-end ratio, before making a final decision on whether to extend a mortgage loan. The front-end ratio only considers debt directly related to a mortgage payment. It is calculated by adding the mortgage payment, homeowner’s insurance, real estate taxes and homeowners association fees (if applicable) and dividing that by the monthly income. For example: If monthly mortgage payment, insurance, taxes and fees equals $2,000 and monthly income equals $6,000, the front-end ratio would be 30% (2,000 divided by 6,000). Lenders would like to see the front-end ratio of 28% or less for conventional loans and 31% or less for Federal Housing Association (FHA) loans. The higher the percentage, the more risk the lender is taking, and the more likely a higher-interest rate would be applied, if the loan were granted. Back-end ratios are the same thing as debt-to-income ratio, meaning they include all debt related to mortgage payment, plus ongoing monthly debts such as credit cards, auto loans, student loans, child support payments, etc. Why Debt-to-Income Ratio MattersWhile there is no law establishing a definitive debt-to-income ratio that requires lenders to make a loan, there are some accepted standards, especially as it regards federal home loans. For example, if you qualify for a VA loan, Department of Veteran Affairs guidelines suggest a maximum 41% debt-to-income ratio. FHA loans will allow for a ratio of 43%. It is possible to get a VA or FHA loan with a higher ratio, but only when there are compensating factors. The ratio needed for conventional loans varies, depending on the lending institution. Most banks rely on the 43% figure for debt-to-income, but it could be as high as 50%, depending on factors like income and credit card debt. Larger lenders, with large assets, are more likely to accept consumers with a high income-to-debt ratio, but only if they have a personal relationship with the customer or believe there is enough income to cover all debts. Remember, evidence shows that the higher the ratio, the more likely the borrower is going to have problems paying. Is My Debt-to-Income Ratio Too High?The lower your debt-to-income ratio, the better your financial condition. You’re probably doing OK if your debt-to-income ratio is lower than 36%. Though each situation is different, a ratio of 40% or higher may be a sign of a credit crisis. As your debt payments decrease over time, you will spend less of your take-home pay on interest, freeing up money for other budget priorities, including savings.[CP_CALCULATED_FIELDS id=”6″] How to Improve Your Debt-to-Income RatioThe goal is usually 43% or less, and lenders often recommend taking remedial steps if your ratio exceeds 35%. There are two options to improving your debt-to-income ratio:
Neither one is easy for many people, but there are strategies to consider that might work for you. Lower your debt paymentsFor most people, attacking debt is the easier of the two solutions. Start off by making a list of everything you owe. The list should include credit card debts, car loans, mortgage and home-equity loans, homeowners association fees, property taxes and expenses like internet, cable and gym memberships. Add it all up. Then look at your monthly payments. Are any of them larger than they need to be? How much interest are you paying on the credit cards, for instance? While you may be turned down for a debt consolidation loan because of a high debt-to-income ratio, you can still consolidate debt with a high DTI ratio with nonprofit debt management. With nonprofit debt management, you can consolidate your debt payments with a high debt-to-income ratio because you are not taking out a new loan. You still qualify for lower interest rates, which can lower your monthly debt payments, thus lowering your ratio. Remember that improving your DTI ratio is based on debt payments, and not debt balances. You can lower your debt payments by finding a debt solution with lower interest rates or a longer payment schedule.Other alternatives worth considering to lower your expenses and pay off debt:
Most important, make a realistic budget designed to lower your debt and stick with it. Once a month, recalculate your debt-to-income ratio and see how fast it falls under 43%. Increase Your IncomeImproving the income side almost always is more difficult because it requires the one thing no one has enough of – time. Finding a night-time or weekend job that produces even a couple of hundred dollars could be the difference maker in getting your debt-to-income ratio below 43%. Here are some ways to increase your income:
Finding a combination of the two – part-time job, plus reducing expenses – is the ultimate solution and might even bring your debt-to-income ratio below the 36% level that lenders are anxious to do business with. If working extra hours doesn’t appeal to you, remember – this is just temporary. You can use the income to pay off debt, reducing your ratio and your need to work extra. Does My Debt-to-Income Ratio Affect My Credit Score?The good news if you have high debt-to-income ratio is that it has no bearing on your credit score, because credit-rating agencies don’t include your income among their credit scoring factors. The bad news: Maxing out your credit cards will nevertheless damage your score. Rating agencies do factor your credit utilization rate (i.e. how much of your credit limit that you use) in determining your score, so it’s no surprise that people who carry high debt burdens often have low credit scores. For example, if you have a $10,000 limit on your favorite credit card and your current card balance is $9,000, the resulting credit-utilization ratio of 90% won’t reflect kindly on your credit score. Lower credit-utilizations rates equal higher credit scores (not to mention better financial health), with a long-held rule of thumb being to keep balances below 30% of your credit limit. That means living within your means and paying off your credit card balance whenever possible. Why Is Monitoring Your Debt-to-Income Ratio Important?Calculating your debt-to-income ratio can help you avoid “creeping indebtedness,” or the gradual rising of debt. Impulse buying and routine use of credit cards for small, daily purchases can easily result in unmanageable debt. By monitoring your debt-to-income ratio, you can:
Creditors look at your debt-to-income ratio to determine whether you’re creditworthy. Letting your ratio rise above 40 percent may:
Debt-to-income ratios are powerful indicators of creditworthiness and financial condition. Know your ratio and keep it low. What is a debtdebt-to-income ratio. This is the percentage of gross monthly income that goes toward paying for your monthly housing expanse, alimony, child support, car payments, and other installment debts, and payments on revolving or open-ended accounts, such as credit cards.
Which of the following indicates the percentage of your income that you are spending to pay down your debts?Your debt-to-income ratio, or DTI, is a percentage that tells lenders how much money you spend on paying off debts versus how much money you have coming into your household. You can calculate your DTI by adding up your monthly minimum debt payments and dividing it by your monthly pre-tax income.
Which of the following is income from a loan quizlet?Which of the following is income from a loan? The answer is finance charges. Income on the loan is realized from two sources: finance charges collected at closing and recurring income, the interest collected during the term of the loan.
Which of the following refers to placing more value on the present at the expense of the future quizlet?Procrastination means: placing more value on the present at the expense of the future. Most people dislike losing, especially money. In other words, people tend to be loss-averse.
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