The Importance of Debt to Income Ratio
When it comes to obtaining credit, one of the most important factors is your debt to income ratio. This is information is vital if you are applying for an auto loan, credit card, or mortgage. On any application, you will be asked to provide your income. The creditor will use this information along your debt amount to figure out what your debt to income ratio is. Here is a guide to how it works.
How to Calculate
In order to figure this out, you first need your monthly income. This is fairly easy to determine. All you need to do is divide your annual salary by 12. This will give you your monthly income. For the sake of this calculation, use your gross income and not your net income. Gross income is what you make before taxes and other deductions.
Next, add up your regular expenses. This includes car payments, student loans, minimum credit card payments, and any miscellaneous payments. You do not need to count utilities or incidental expenses. You also want to count your living payments. If you pay rent, this is fairly simple to include. If you pay a mortgage, you want to make sure you include your insurance and other expenses. Add all of these expenses up and divide that number by your gross monthly income. This gives you your debt to income ratio.
Uses of the Ratio
Creditors use this ratio to determine your ability to repay a debt. A high debt to income ratio indicates that you may have trouble managing a new loan. A low ratio indicates that you are financially stable. Basically, this ratio tells a creditor if you are able to hander additional debt.
Recommended Ratios
Generally speaking, most lenders look for a debt to income ratio of .36, or 36%. This is the standard used by most mortgage companies. If your ratio is higher than this, you run the risk of being denied credit. At the very least, you can expect higher interest rates. Lenders also look at your total living expenses. The target ratio of living expenses is .28, or 28%. Again, just because you are above this ratio doesn't mean you will definitely be denied. FHA and VA mortgage loans look for a ratio below .41. That is the major exception to the rule.
Before you apply for a new loan, it is a good idea to calculate your debt to income ratio. You can calculate it based on what you pay currently or what you will expect to pay should you get a loan. If you find yourself with a ratio that is at or above the recommended range, consider paying off debts before applying for the loan.