Debt-to-income ratio

What is a debt-to-income ratio? Why is the 43% debt-to-income ratio important?

Answer: Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. This number is one way lenders measure your ability to manage the payments you make every month to repay the money you have borrowed. To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out. For example, if you pay $1500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2000. ($1500 + $100 + $400 = $2,000.) If your gross monthly income is $6000, then your debt-to-income ratio is 33 percent. ($2000 is 33% of $6000.) Evidence from studies of mortgage loans suggest that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. The 43 percent debt-to-income ratio is important because, in most cases, that is the highest ratio a borrower can have and still get a

Qualified Mortgage. There are some exceptions. For instance, a small creditor must consider your debt-to-income ratio, but is allowed to offer a Qualified Mortgage with a debt-to-income ratio higher than 43 percent. In most cases your lender is a small creditor if it had under $2 billion in assets in the last year and it made no more than 500 mortgages in the previous year.Larger lenders may still make a mortgage loan if your debt-to-income ratio is more than 43 percent, even if this prevents it from being a Qualified Mortgage. But they will have to make a reasonable, good-faith effort, following the CFPB’s rules, to determine that you have the ability to repay the loan.

Lenders Look at More Than Just Your Credit Score

If you’re in the market for a loan, your credit score is one of the biggest factors lenders consider, but it’s still just the start. Lenders like to see an applicant’s full financial profile when deciding whether to approve a loan and at what interest rate. So when you fill out a loan application, be prepared to share everything.

What lenders look at in your application CREDIT REPORT

Your credit score is like the CliffsNotes for your credit history, giving a brief overview so the lender doesn’t have to dive too deeply into your credit reports. However, the lender may still choose to investigate further if something looks off. It may look for:

• Delinquent accounts

• Unpaid collection accounts

• A past bankruptcy

• Foreclosures, unpaid tax liens or civil judgments

• The number of recent hard credit inquiries

• Outstanding debts

While one or more blemishes might not be deal-breakers, having them on your credit report can affect your rate.

INCOME AND EXPENSES

The lender is less likely to view you as a risk if you have a higher income, because you’re more likely to be able to pay all your obligations every month. On the flip side, a high income may not help you get a better rate if your fixed expenses, such as your rent or mortgage payment, are especially high. For example, when applying for a mortgage, your total debt-to-income ratio must be 43% or lower to qualify for a loan with a reputable lender.

DOWN PAYMENT

he lower your loan amount, the less risk to the bank. Therefore, if you have a large down payment, the lender is more likely to be generous with the interest rate. If your credit score is borderline and you don’t qualify for a loan, a sizable down payment might even help you get approved. Keep in mind that a slightly lower interest rate may not be worth cleaning out your bank account. It’s important to keep enough cash in savings in case of an emergency.

LOAN TERM

The length of the loan is important to lenders because a longer loan term gives more time for a default. Therefore, you can typically find a 15-year mortgage with a lower interest rate than a 30-year mortgage. Keep this in mind when you are applying for a loan. If you can afford a loan with a shorter term, your monthly payment may be higher, but you’ll pay less in interest over the life of the loan, and you’ll be out of debt sooner.

COLLATERAL

If you’re applying for a car or home loan, the lender will look closely at the value of the vehicle or house because it will act as collateral for the loan. For example, say you want a $15,000 car. Add in $5,000 in after-market warranty and maintenance contracts, gap insurance and sales tax, and you’re seeking a loan for $20,000. Your loan-to-value ratio is 133% ($20,000 / $15,000 = 1.33). In this case, if the vehicle is totaled or you default on the loan and the lender tries to resell the car, it most likely won’t recoup the full $20,000. Therefore, the lender will likely call for a higher interest rate to compensate for the risk.

A loan with collateral, or a secured loan, typically comes with a lower interest rate than an unsecured loan because you’re pledging the collateral as repayment of the loan if you fail to make payments. We recommend caution when considering using your house or car as collateral when applying for a personal loan. If you default, you can lose your asset.

LIQUID ASSETS

You’re expected to use your income to repay the loan, but some lenders may want to know whether you have assets that can be converted into cash quickly to make payments in case you lose your job or experience other financial setbacks. These assets can be in the form of a savings or money market account, stocks or government bonds. If you have enough liquid assets to cover the cost of the loan, the lender may view you as less risky and may offer you a lower rate.

EMPLOYMENT HISTORY

If you’re applying for a mortgage, your current income may be enough to qualify you for a good rate. But the lender may choose to review your income from the past 24 months to measure income stability. If you have a spotty job history or you were unemployed recently, you might not be denied, but the issuer may still view it as a red flag. As a result, you could end up with a higher interest rate.

What you can do

You can improve your chances of loan approval with favorable terms by developing good credit behaviors like paying your bills on time and keeping your credit card balances low. Another strategy is to avoid applying for more credit than you can afford. In other words, if you have weaknesses in any of the aforementioned areas, borrowing conservatively can lower the overall risk of the loan to the lender, and these factors will have less of an effect.

What is a good debt-to-income ratio, anyway?

By Thomas Bright May 20th, 2014 Managing Credit and Debt

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If you’ve spent any time on our website or talking with one of our counselors, you know how important a debt-to-income ratio can be. This tool, often used by lenders, can also help us evaluate the health of our individual financial situations. The formula is simple; all you have to do is divide your total debt by your total income and then convert the decimal to a percentage. For a monthly look, take your monthly debt and income figures and use those instead. Oh, and even though the method is simple, we still have a calculator to make it even easier for you. What’s less simple, however, is understanding the significance of your ratio and what it can mean for your overall finances.

Three Levels of Debt-to-Income Ratios

In the credit counseling world, we think of a debt-to-income ratio as being divided into three main tiers. It’s a lot like a traffic light, with a green (safe), yellow (caution), and red (danger) level. We think that being at or under 15 percent is safe, between 15 and 20 is getting into risky territory, and above 20 percent is a dangerous level. And just to clarify, we are talking about non-mortgage debt here (more on mortgage ratios below).

Tier 1 – 15 Percent

At 15 percent, you will have enough remaining income to devote to things like housing, food, transportation, and so on. In fact, here’s a look at how this can all come together in an ideal situation (this chart is based on net income):

If something unexpected were to pop up, you might also be better prepared if your debt-to-income ratio and overall spending plan looked like this. Of course, we hope you have a healthy emergency savings fund set aside, but even if you were forced to take on new debt as a result of something unexpected, you would probably be OK due to already having it at such a manageable level of 15 percent. For reference, an annual income of $35,000 comes out to a monthly income of about $2,917. A debt-to-income ratio of 15 percent would mean your total non-mortgage debts costs $437.50 or less each month.

Tier 2 – 15 to 20 Percent

The next tier is a debt-to-income ratio of between 15 and 20 percent. Using our previous example, if you make $35,000, a debt-to-income ratio of 20 percent means that your monthly debt costs $583.40. At this point, we often find that consumers are still okay and can keep their heads above water. Most likely, they will need to get on a self-pay method, such as the debt ladder or debt snowball and use their self-discipline to stay on top of their debts. But, some consumers might really begin to struggle at this level. After all, how did the debt-to-income ratio slip to this point to begin with. Is it due to an unforeseen event or a need to take out new credit? Is it due to a loss in income that has made minimum payments unbearable?

Slipping into this range could be a sign of more trouble to come. Because of this, we recommend that consumers take action at this point. In fact, we offer a free budget and credit counseling session that allows consumers to gain control of this situation. A counselor can help you determine if there is room in your budget to cut expenses and devote more money to your accounts or if your situation might be better suited for a Debt Management Program, especially if you are balancing multiple high-interest debts.

a Debt Management Program, especially if you are balancing multiple high-interest debts.

Tier 3 – 20 Percent and Above

Lastly, the tier of 20 percent and above is the most dangerous. For a base income of $35,000, a 25 percent debt-to-income ratio would mean that your monthly debts total $729.25! At this stage, it’s pretty clear that something isn’t quite right. You have more debt than you can really afford. This doesn’t mean that it’s impossible to make it on your own, but it will be tough. You should definitely talk to a credit counselor and see what your best options are.

What about for mortgages?

Debt-to-income ratios are much different when we think about mortgages. There are two terms related to mortgage and debt-to-income ratios that you should know: front-end and back-end. A front-end ratio is the percentage of your income that would be devoted to housing costs. When a lender is determining whether they will offer you a loan at a given amount, they will take your gross income, multiply it by their required front-end ratio and come up with a total. This total will be the amount you can pay toward housing, and they may not award you a loan that would exceed this amount. Here’s a quick example, using our hypothetical $35,000 salary and a maximum front-end ratio of 25 percent. We are using 25% because that’s the “ideal” amount to spend on housing, based on our spending plan above:

In this example, a lender would likely not want to award you a loan that would require you to pay more than $729 per month in housing costs. This assumes that the lender is using a 25 percent maximum and that their are no other income earners, such as a spouse, in the equation.

The lender will also multiply your gross income by the back-end ratio, which is a higher figure. The back-end ratio is higher because it includes your housing expenses along with all other debts. So, this includes the front-end and anything else, like credit cards and student loans. Again, this calculation will return a dollar figure, and your total debt commitments should not exceed it.

Another example, using a back-end ratio of 36 percent:

Thanks for Reading!