Excluding the unforeseeable bumps in your financial road, you can predict how much you will spend each month on debt, housing, food, utilities, and even occasional wants. If the amount you spend on debt payments each month gets too high, you may find yourself in a position where you are unable to adequately pay for important needs. Debt is unavoidable, but having sufficient income after paying debts each month shows lenders that you are able to handle debt and that you don’t live too close to the edge. But what is a good debt to income ratio?
Calculating Debt-to-Income Ratio
One of the frequently asked questions we get is “What is a good debt to income ratio?” If you feel like there isn’t enough money at the end of the month to pay everything you need to, it might be because you have a very high debt-to-income ratio. In order to calculate the percentage, divide all of your total debt payments for each month by your total gross monthly income. For example, if you earned $6,000 every month (before deductions and taxes) but also paid $2,000 into debt, the calculation would look like this:
6000 / 2000 = .33 (33% DTI)
Like credit scores, debt-to-income ratios also have a range of acceptability, which is generally divided into three levels:
- Good: less than 15%
- Caution: between 15 and 20%
- Danger: greater than 20%
These levels (which do not include mortgage debt) indicate how well you will be able to pay remaining responsibilities after all debt has been paid for the month, and you can see that the example equation above is well into the danger zone for high DTI.
Debt-to-income works a little differently with mortgages than it does for acquiring other types of debt. In order to calculate a loan amount, the lender will likely perform two equations using two different ratios: front-end and back-end. Both ratios are multiplied by your gross income to tell you the maximum amount of money you should devote to housing costs. For example, if the lender’s front-end ratio is 25 percent and your monthly income is $3,000, a lender would likely only fund a loan that charges you monthly payments of $750 or less. The back-end ratio however, will be higher since it includes housing debt and other debt (such as credit cards).
If the total amount of your other debts is very high, then this will affect how much the lender is willing to lend you or if you’ll be approved for a loan at all. This is where your DTI really comes into play. Take a look at these new equations using the back-end ratio:
Situation 1: Borrower’s DTI is at 15 percent of their monthly income of $5,000, meaning they pay $750 into debt every month. Using a back-end ratio of 36 percent, the total debt amount could not exceed $1,800, so the lender would likely approve a loan with monthly payments equal to or less than $1,050.
$5,000 x .36 = $1,800
$1,800 – $750 = $1,050
Situation 2: Borrower’s DTI is at 25 percent of their monthly income of $5,000, meaning they pay $1,250 into debt every month. Using the same back-end ratio of 36 percent, the borrower’s total debt amount could not exceed $1,800, but since they’re already paying $1,250 for debt every month, this means the lender would only approve a loan with monthly payments equal to or less than $550.
$5,000 x .36 = $1,800
$1,800 – $1,250 = $550
Lower Your DTI for More Loan Benefits
As you can tell by the examples above, a higher debt-to-income ratio significantly limits your options when purchasing or refinancing a house while a healthy debt to income ratio increases your options. An ideal debt to income ratio may even grant you lower interest rates. It’s important to work on lowering your DTI to get all the benefits from your home loan that you can. At the same time, remember that every lender has different requirements. The acceptable ratio for total debt when it comes to mortgage lenders is around 41 to 43 percent, but check with your lender to get specifics.
At Low VA Rates, we try to help anyone who is struggling with their finances. If you have questions about the topic what is a good debt to income ratio. Give us a call now for a free consultation.