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Unless you come by a huge inflow of money either by winning the lottery or by inheritance; a mortgage remains the most affordable way to own a home. Among the tools lenders use to determine your eligibility for a home loan is the debt-to-equity ratio, or DTI.
The ratio is used to determine how much of your income can be allocated to monthly mortgage payments versus other monthly debts that your income settles. Read on to learn how to calculate DTI and what ranges are desirable by industry standards.
What is a debt to income ratio and how is it calculated?
A debt to income ratio is a number used to measure a person’s ability to manage debt. This number is calculated using two key financial pieces of information: your debt and your income. By taking your total monthly debt and your total monthly income, which includes any money earned before taxes and deductions, you can determine your debt-to-income ratio.
In another example where total debt is greater than $1,500 and income is still $4,000, you see an increase in DTI. If you have monthly debt payments equal to $2,000 and your gross monthly income equals $4,000, your debt-to-income ratio will be 50%.
STEP 1. Determine your monthly liabilities. These include:
Monthly home expenses – If this is your first mortgage, this will be the sum of all monthly expenses that will be used to pay your rent. It should be expressed as a monthly amount, i.e. if you pay an annual sum, divide it by 12. Similarly, if you pay it quarterly, divide it by 4. Add the monthly payment proposed or planned for the mortgage you are considering.
It will also include other housing costs such as mortgage insurance, property taxes and homeowners association payments. If you own a home in the second mortgage market, the monthly payments you make for your first mortgage will make up the cost.
Although you can pay for utilities such as electricity and gas monthly, they are not included in this sum. The same goes for food, health and car insurance, the phone bill, your taxes and the cable bill.
Loan installments – A sum of all monthly loans that are deducted from your salary and appear on your credit report. These include monthly payments for car loans, student loans, credit unions, and personal bank loans.
Monthly credit card payments – This is the sum of the minimum payments you make for each credit card. This excludes credit card debts that you pay in full monthly.
Other monthly obligations – It can be any other line of credit involving financing. Monthly alimony or alimony payments fall under these obligations.
ADVICE: Monthly debts = (House costs + loan repayments + credit card payments + other)
Step 2. Determine your monthly gross income
This refers to your total salary before any deductions or simply your pre-tax salary. This includes;
- Basic salary or salary.
- Bonuses and commissions
- Alimony and/or alimony.
- Investment income (must be verifiable through your tax returns)
Advice: If you receive a salary, bonus or commission annually, divide it by 12 to arrive at its monthly value.
How to Calculate Frontal Ratio
It’s the house-related expenses divided by your monthly gross income. It indicates the amount of monthly income that can be released to service the home loan you are offering to obtain. To put this into context, let’s say your gross monthly income is $6,000 and your total monthly home expenses are $1,500.
Front end DTI = ($1,500/$6,000) * 100 = 25%
How to calculate the backend ratio
When lenders talk about DTI, that’s mostly what they have in mind. It is a ratio that shows the amount of your income that is used to settle all your debts. It is the sum of all monthly debts divided by your monthly gross income. Let’s say your total monthly liability (including house-related expenses) in the example above is $2,500,
Primary DTI = ($2,500/$6,000) *100 = 41%
Norms for the debt-to-income ratio
A DTI low means you have more income left over after paying your bills. A back-end ratio of 36% and a front-end ratio of 28% or less are considered favorable by most lenders.
Final ratios between 36% and 49% translate to less amount to spend. Lenders will view you as a potential defaulter. You may have to deal with higher interest rates and huge down payments for your loan.
Anything above 50% puts you in the red. This means that half of your salary goes towards paying off your debts, leaving you with little to spend or even take on a new financial obligation. This greatly reduces your chances of getting a mortgage.
What is the ideal debt to income ratio?
If you don’t plan on applying for a car or home loan, opening a credit card account, moving into a new apartment, or doing anything else that requires someone to check your credit and your finances, you may not care too much about your DTI. . But when you’re looking for credit, part of the application process can include a thorough review of your finances. Although it varies, each creditor and lender has certain criteria applicants must meet to approve an application, so they might be interested in reviewing your DTI to determine if you should be approved.
Since this number provides insight into how well you manage your debt, especially your ability to repay debt, the higher your DTI, the more likely you are to be denied. Creditors will look for borrowers whose debt-to-equity ratio does not exceed 43%. This means that if your monthly income is $4,000, your total monthly debt payments should not exceed $1,720. Although 43% is acceptable to most creditors, a lower DTI is even better.
Improve your debt to income ratio
If your DTI is over 43%, you have the power to change it. Since your monthly debts and your income are the two important factors used to determine your DTI, there are several ways to lower your DTI and get in a better financial position.
If you want to improve your debt-to-income ratio, one thing you can do is reduce the total amount of debt you owe. If you took out a loan of $5,000, your monthly loan payment will be included in your debts used to calculate your DTI. By making additional payments on your loan, you will be able to pay off the loan faster and reduce the amount of debt owed.
Additionally, if you want to improve your DTI, you can also avoid adding to your current debt or increasing your monthly income by taking paid full-time, part-time, or position employment.