Debt-to-Income Ratios 101
If you have ever applied for a loan, whether it be for a car, a home equity loan or for a home mortgage, you probably had a loan officer mention your "debt to income ratio" or DTI. This calculation is one that loan officers deal with every day. It is perhaps the number one factor they use to determine someone's ability to repay back a loan. Read on to find out how your DTI could affect your next loan application.
What is a Debt to Income Ratio?
A person's debt to income ratio compares all of your monthly debt payments to your monthly income to determine how easily you could handle new payments. It's a way for lenders to evaluate their level of risk as a lender before approving your loan application. From their perspective, if you already have a lot of debt compared to the amount of money you earn, it may be harder for you to repay another loan.
On the other hand, if your debt to income ratio is low, it indicates that you're more likely to have available income to put towards another loan. So, the better your DTI ratio, the better chance you have of getting your loan application approved.
How do you calculate your DTI?
Start by listing out all of your monthly debt payments. This includes your monthly credit card payments, student loan payments, and car loan payments. Add those numbers together and divide that by your gross monthly income (the money you earn before taxes) and you get your current DTI.
Here's an example. Say you have a $150 monthly car payment, $200 student loan payment, $1,200 mortgage, and $75 in credit card payments. Your monthly debt obligations total $1,625. If your pre-tax income is $3800 a month then you divide the two numbers to get 0.43, or 43%.
When applying for a new loan, you also need to add in the expected monthly payment for your new loan. That final number is what your lender looks at to determine whether or not your DTI meets their qualifications.
A Debt-to-Income Calculator: http://www.bankrate.com/calculators/mortgages/ratio-debt-calculator.aspx
Where do lenders get your financial information?
Lenders typically use two sources to get your financial information. The first is your credit report and the second is financial information comes from you.
Your credit report supplies all of your loan balances and credit card balances so lenders know exactly how much you owe. A potential problem you may run into is the fact that credit reports can take a month or more to update new information. So, if you just made a large payment on one of your credit cards, that new balance might not be reflected on the credit report pulled by your lender for several weeks.
Your lender will ask you to verify your monthly income with documentation such as pay stubs and bank statements. You'll also need to submit at least two years of W-2s and/or tax returns.
What is an ideal debt to income ratio?
The answer to this question really depends on the lender you are working with, but obviously the lower your DTI ratio, the better. If you would like a typical number, conventional lenders use 36% as a target DTI. But, of course each situation is different and depending on your other financial obligations, a higher or lower number may be appropriate.
Debt to income ratio is a simple tool used by lenders when evaluating loan applicants. Now that you understand the ins and outs of DTI ratio and its effect on your ability to get a mortgage, you can make more informed decisions when considering the purchase of something via a loan.