Handshakes are great, but banks want to see hard data before they give you hundreds of thousands of dollars. One of the ways they determine whether you can repay a loan is by examining your debts and income to calculate your debt-to-income ratio.
What is Debt-to-Income Ratio?
Your debt-to-income ratio is a metric that explains how much of your income is used to service your debts. It uses a percentage to help you and lenders understand what portion of your earnings goes straight to your debt obligations.
Lenders use the debt-to-income ratio to determine if you’re in a good financial position to borrow more money. Naturally, they don’t accept your promises. They want assurances that you can actually pay your loans. They’d rather do the math themselves to make sure the loan payment fits into your budget. They’ll deny your loan applications if your debt-to-income ratio is too high.
The debt-to-income ratio is also a useful tool to gauge the health of your own financial situation. It helps you understand how much money you ultimately have to work with each month after paying your debts.
How Does the Debt-to-Income Ratio Work?
You’ve probably come across the debt-to-income ratio without even knowing it. When you fill out an application for a credit card, a student loan, or amortgage, the lender often wants to know how much money you earn and how much you spend on monthly expenses. These are the primary variables used to calculate the ratio.
Ratios greater than 100% indicate that you owe more each month than you earn. This is an extremely dangerous and unsustainable situation because it means you need to constantly borrow money to pay your obligations.
But just because your debt-to-income ratio is less than 100% doesn’t mean it’s safe to borrow money. You still need a portion of your income to pay for living expenses, like utility bills, your cell phone, food, and all those day-to-day expenses that always seem to pop up. So lenders want to see a debt-to-income ratio that’s far below 100%.
Credit bureaus don’t consider your debt-to-income ratio when they calculate yourcredit score. However, people with high debt-to-income ratios tend to have a high credit utilization ratio, which is the percentage of available credit that you’re currently using. (E.g. If you have $500 on a credit cart with a limit of $2,000, your credit utilization is 25%.) Credit utilization is a factor that accounts for about 30% of your credit score.
How to Calculate Debt-to-Income Ratio
Calculating your debt-to-income ratio is a little more complex than it seems at first glance because there are actually two ratios: Front end and back end.
1. Front End Debt-to-Income
Your front end debt-to-income ratio is also called your housing ratio. It’s used almost exclusively during a mortgage application. It calculates how much of your monthly pretax income will go toward your mortgage. Lenders want to make sure that a single loan won’t eat up too much of your income.
Front end debt-to-income = (total loan cost) / (total income)
Let’s say Mark earns $5,200/month and wants to take out a $1,100/month mortgage. It will also require $125/month in mortgage insurance, $110/month in homeowner’s insurance, and $185/month in property taxes. In the end, his mortgage will cost $1,520/month.
Front end debt-to-income = (1,100 + 125 + 110 + 185 ) / 5,200 = 29%
2. Back End Debt-to-Income
Your back end debt-to-income ratio is the default term when people discuss debt-to-income. It’s a more comprehensive figure because it considers all of your monthly debt obligations, including the loan you’re trying to take out. If this value is too high, it could mean that you don’t earn enough money to pay your debts. Naturally, lenders don’t like this scenario.
Back end debt-to-income = (total expenses) / (total income)
We’ll use Mark for another example. His mortgage will cost $1,520/month, but he also has a credit card that costs $135/month, a student loan at $315/month, and a car payment at $155/month.
Back end debt-to-income = (1,520 + 135 + 315 + 155) / 5,200 = 41%
Keep in mind that your debt-to-income ratio isn’t the only factor you should consider when you take out a loan. You should also calculate other expenses that aren’t technically debts, but still chip away at your income. Your utility bill, for example, isn’t a debt, but it’s an expense you deal with every month. These kinds of expenses should be part of yourpersonal finance calculations.
What is a Good Debt-to-Income Ratio?
The best debt-to-income ratio is 0%, which means you have no debt. But that isn’t a reasonable position for most people. Most of us have a car payment, a student loan, credit cards, etc.
The real question is “What debt-to-income ratio do banks want to see?”
35% or less:This is the safe zone. It means that you most likely have money each month after you pay your bills for living expenses and emergencies. It also means you can probably take on additional debt at a moment’s notice forseriousemergencies (like if you need to open a credit card to visit a sick relative, for instance).
36% to 49%:If you fall into this bracket, you have room to improve. Take steps to lower your debt-to-income ratio so you’ll have more wiggle room to handle unforeseen circumstances. If you need ahome equity loanto repair a roof emergency, for example, the last thing you want to do is struggle with loan application.
50% or more:This is a dangerous zone. It means more than half of your income goes to debt. After your living expenses, you won’t have much to protect yourself from sudden costs. Lenders will limit your borrowing, charge large fees to compensate them for risk, or deny you outright. Take action immediately.
It’s important to understand that those are just general figures. Each lender will have different criteria. A lender may consider you a safe bet if your debt-to-income ratio is high. It depends on how much risk they’re willing to take and how the loan is structured.
Most lenders also take your specific financial situation into account. For example, a lender may approve your loan application even though your debt-to-income ratio is a little high because they have solid evidence that your income will increase soon.
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What Debt-to-Income Ratio Do You Need for a Mortgage?
The maximum debt-to-income ratio you can have in order to take out a qualified mortgage is 43%. A qualified mortgage is a type of loan that has stable features and protections for home buyers.
One of those protections is the ability-to-repay rule, which requires lenders to make a good faith effort to determine whether you can repay the loan. If a bank gives you a qualified mortgage, it means they believe that you can repay it. Lenders are not allowed to give you a qualified mortgage if your debt-to-income ratio is higher than 43%.
Can you get an _non-_qualified mortgage without the debt-to-income ratio limit? Yes, but lenders are still subject to the ability-to-repay rule, so there will be additional hoops to jump through and you’ll probably pay a higher rate.
Even a 0.25% increase of theinterest ratecould costthousandsof dollars over the life of a mortgage, so it’s usually less expensive to reduce your debt-to-income ratio rather than take out a non-qualifying mortgage.
How to Improve your Debt-to-Income Ratio
Your debt-to-income ratio shows the relationship between two numbers: total debts and income. You can affect the ratio by changing one or both of those numbers.
This means there are two ways to lower your debt-to-income ratio: Increase your income or reduce your debts. Simple to do, but not necessarily easy.
Your first step is to create apersonal budgetif you haven’t already. Use it tomanage your moneyby tracking your expenses (no matter how small) and eliminating unnecessary purchases.
Reduce Your Debts
Decreasing your debt is as simple as paying it down quickly. (Not that that’s easy, of course.) Pay off your smaller balances first so they are no longer a monthly obligation.
If your accounts are in good standing, contact your lenders and request lower interest rates. Some will reduce your rate in order to keep your business. If your credit lenders won’t reduce your rates, consider transferring your balances to a 0% or low interest card.
If you have a lot of loan accounts, consolidate them into a single loan with a lower monthly payment. Keep in mind, however, that while this will lower your debt-to-income ratio, but smaller monthly payments usually meanmoretotal payments, which may affect how much you pay in total. You’ll have to decide if lowering your debt-to-income ratio is worth paying more overall.
Most importantly, stop taking on new debt! Don’t make purchases on your credit cards and avoid taking out any new loans.
Boost Your Income
To increase your income, you could…
Ask for a raise at work
Volunteer for overtime
Change to a higher paying position
Find a new, higher paying job
Take on a part-time job
Start a side business
Lenders will want to see proof of this new income on your bank statements. They usually require two months of recent statements, but they may ask for more.
Less Debt, More Income
The big takeaway here shouldn’t shock you: Lenders prefer you to have less debt and more income. If you push your income as high as possible and reduce your debt as much as you can (preferably to $0), you’ll have a much easier time borrowing money in the future. You’ll also have an overall healthier financial position and a lot less stress in your life.
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June 6, 2022
As a financial expert with a deep understanding of personal finance and lending practices, I can provide insights into the concepts discussed in the article about debt-to-income ratio.
The debt-to-income ratio is a crucial metric used by lenders to assess an individual's financial health and ability to take on additional debt. This ratio is calculated by dividing the total debt obligations by the total income and is expressed as a percentage. Lenders use this information to determine whether an individual is in a suitable financial position to borrow more money.
There are two main types of debt-to-income ratios mentioned in the article:
Front End Debt-to-Income Ratio (Housing Ratio):
- This ratio focuses on the portion of monthly pretax income dedicated to housing expenses, primarily during mortgage applications.
- The formula is Front End Debt-to-Income = (Total housing expenses) / (Total income).
Back End Debt-to-Income Ratio:
- This is the more comprehensive ratio that considers all monthly debt obligations, including the loan being applied for.
- The formula is Back End Debt-to-Income = (Total monthly expenses) / (Total income).
The article emphasizes the importance of maintaining a healthy debt-to-income ratio. Ratios less than 100% indicate a sustainable financial situation, while ratios above 100% signal a risky scenario where constant borrowing is needed to meet obligations.
Credit bureaus don't directly consider the debt-to-income ratio when calculating credit scores. However, individuals with high debt-to-income ratios often have high credit utilization ratios, impacting about 30% of their credit score.
The article also provides guidelines for what lenders generally consider as acceptable debt-to-income ratios:
- 35% or less: Safe zone, indicating financial stability.
- 36% to 49%: Room for improvement, with steps recommended to lower the ratio.
- 50% or more: A dangerous zone, where more than half of income goes to debt, leading to potential borrowing limitations and high fees.
For mortgage applications, the article mentions that the maximum debt-to-income ratio for a qualified mortgage is 43%. Lenders are not allowed to offer qualified mortgages if the ratio exceeds this limit, ensuring borrowers' ability to repay.
To improve one's debt-to-income ratio, the article suggests increasing income or reducing debts. Strategies include negotiating lower interest rates, consolidating loans, and avoiding new debt. The ultimate goal is to have less debt and more income, creating a healthier financial position for borrowing in the future.
In conclusion, understanding and managing your debt-to-income ratio is crucial for financial well-being and plays a significant role in loan approvals, particularly in mortgage applications.