So, you’re trying to line up financing for that luxury car you’ve always wanted; or that new addition on the house your wife has been “gently” reminding you of; or how about the new sports boat to take the kids water skiing every other weekend? Well, in order to make any of these things happen, most of us turn to our friendly local bank to inquire about a loan to turn our dreams into a reality. Your average banker will often tell you that yes, they finance such requests as those mentioned above. All you have to do is fill out an application, then he or she will run your credit report and take a look at your DTI. This is where you stop and think to yourself, “I know what a credit score is, but what is this DTI they are referring to?”
What it is:
DTI stands for debt to income ratio. Okay, so what is debt to income ratio? Debt to income ratio is a personal finance measurement that compares the amount of money you earn to the amount of money you owe your creditors. Banks and lenders calculate how much debt their customers can take on before they may start having financial difficulties. The banks and lenders then use these calculations to set lending amounts before approving any new debt the customer is looking to take on. Preferred maximum debt to income ratios will vary from lender to lender, but you can count on a figure somewhere between 36% and 40% as the norm maximum debt to income ratio.
How to calculate it:
To calculate debt to income ratio, first add up all the payments you make each month to service your debt. Such debt often includes your housing expense (mortgage or rent), credit card payments, car loans, and other debts such as student loans, investment loans, etc. Next, divide your total monthly debt by your gross income per month (before taxes), then multiply that number by 100 to get your debt to income ratio as a percentage.
Let's say each month your mortgage payment is $1,400, your car payment is $400 and you pay $200 on credit cards. Totaled, your monthly debt commitment is $2,000 per month.
If you make $54,000 a year, your monthly gross income is $54,000 divided by 12 months for a total of $4,500 per month.
Therefore, your debt to income ratio is $2,000 (outstanding monthly debt payments) divided by $4,500 (monthly income), which works out to about .44 (x 100) you get a 44% debt to income ratio.
In this example, a 44% debt to income ratio, by most bank standards, will be considered high; therefore, if this was your situation, you might be declined for a new loan request. In some cases, however, an approval may be granted, but that approval may come at a cost in which you would be asked to pay a higher than market interest rate for your new loan.
So there you have it - a brief insight of what your banker is referring to when he mentions your DTI ratio. It should be noted that by keeping your debt to income ratio low, you can be assured that you can financially handle the debt you have already taken on, and most likely qualify for future credit. Carefully manage that debt and before you know it, you’ll have that new car, home addition or boat you’ve always wanted!
To easily monitor your debt to income ratio, try Mariner360, our free personal management tool that allows you to aggregate all of your accounts so you can see everything in one place.
Be sure to leave a comment below to let us know if you have any further questions about debt to income ratios or if you would like to hear more about this and similar topics.
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