What Is the Debt to Income Ratio?

Category: Financial.

The debt to income ratio is considered to be a valuable number – some people even say that it is as important as one’s credit score. As the name already suggests, this is a personal finance instrument that measures your amount of debt in comparison with your monthly income. Hence, it indicates the percentage of your income that is directed towards making monthly payments for loans or mortgages.

Therefore, it is crystal clear why most lenders utilize this calculation. Mortgage brokers want to make sure that borrowers can handle the responsibility of making repayments before they accept a loan application. In other words, a broker wants to be 100 certain that your income is high enough so that it covers all your debt. In order to proceed with this calculation, brokers must look at your monthly debt payments and your monthly income.

Of course, that isn’t to say that other factors don’t count. Evidently, there are other elements such as your employment status, your credit score, as well as your personal assets. Even so, these won’t matter too much if your income is too low to cover your outstanding debt.

How to Calculate the Debt to Income Ratio?

This is a fairly simple formula, meaning that you could even calculate it yourself if you want to know what to expect before making a loan application. Here’s the formula: the debt to income ratio = total monthly debt payments/gross monthly income.

This equation clearly places into perspective how much money you earn and the amount that goes towards making debt repayments. Some mortgage providers might change it by taking the mortgage payment out of the equation. This would mean that the debt to income ratio would be calculated based on the monthly debt figure, in order to assess how much money is likely to remain after you’re done with making all the payments.

Analyzing the Debt to Income Ratio: What Is Best?

So, what would be more favorable: a higher or a lower debt to income ratio? Usually, a lower debt to income ratio is preferred. That’s because it points that your monthly debt payments represent a smaller percentage of your monthly income. Therefore, if you were to have lower debt payments, then you could afford a larger mortgage payment and you could deal with your regular living expenses.

There are some things worth noting, though. The standards for acceptable debt to income ratios change over time, depending on geographical position, the industry, as well as the prime interest rate. For instance, someone purchasing a house in South Carolina might enjoy more flexibility in their DTI than in the case of rural Michigan. That’s primarily because the house prices in California tend to be on the expensive side. Therefore, they are prone to appreciate over the course of time.

To conclude, the higher the debt to income ratio, the more difficult it will be for you to deal with the monthly payments. Depending on the lender you’re applying with, your application may or may not be accepted.

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