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What is a Debt-to-Income Ratio?
Lenders use your DTI ratio to evaluate your current debt load and to see how much you can responsibly afford to borrow, especially when it comes to mortgages. Less debt equals more borrowing power, and possibly a higher loan offer. If the debt-to-income ratio is too high, then it may be an indication that the borrower is in serious financial distress.
Should I use my current or future housing costs in the calculation?
If you are in the process of buying a home, you should enter your estimated housing costs. This includes your new mortgage, property taxes and fees. Mortgage lenders use DTI ratios to make sure that you'll not be over-extended with your new loan.
If you are not buying a home, you should use your current housing costs for the calculation.
Should I enter my credit card minimum payments or the amount I really pay each month?
Enter only the minimum credit card payments you are required to pay each month. Also, be sure to include each credit card payment you are required to make each month.
What goes under "other debts"?
Include home equity loans, judgments and any other monthly debts you pay. This may also include rental payments, mortgage payments, insurance, and homeowners’ dues.
The Importance of the Debt to Income Ratio
Our total amount of debt plays a significant role when it comes to our credit standing and financial health. Therefore, it is important to understand how these different components of our credit score affect our life.
The debt to income ratio is one of the most important, and often overlooked, components. It is a comparison of your total monthly debt to your total gross monthly income.
To calculate the debt to income ratio, you should take all the monthly payments you make including credit card payments, auto loans, and every other debt including housing expenses and insurance, etc., and then divide this total number by the amount of your gross monthly income. You will then see a percentage.
A better example:
Your monthly debt payments come to a total of $2000 which is then divided by your gross monthly income of $5,000 which will then provide you with 40%. This percentage is then considered your debt-to-income ratio.
The acceptable DTI ratio will vary depending on the lender, but you will typically want to stay below approximately 36% for a more manageable DTI ratio.
Can I Lower my Debt-to-Income Ratio?
If you have used the formula above to calculate your own DTI ratio and have found that your percentage is above 40%, then there are a few ways you can begin to lower your percentage.
First, you will want to take a closer look at your expenses and determine if you would be capable of paying a bit more toward your overall monthly debt. If you are able to make a few more payments, you can begin to see a decrease in the overall debt amount you are facing.
It is then essential that you avoid building any more debt on top of your existing debt. You want to focus your attention on paying down all current debt and expenses to lower your DTI percentage. It is also recommended that you postpone making any larger purchases that will require you to use a sizeable portion of your available credit.
Once you have followed a few of these steps, you can then try to recalculate your debt-to-income ratio and if needed, find more ways to lower your percentage even further.
A lower debt-to-income ratio will show lenders that you are capable of paying your monthly expenses which means they would be making a sound financial decision to extend you credit because you will be able to follow their repayment terms on the loan.
The bottom line is making sure that you are able to accurately measure your financial security by understanding the importance of learning how to use a DTI calculator. Knowing more about your financial standing will help prepare you if you need to make a major financial decision down the road. It is also helpful when you are looking to make a bigger purchase and want to see if the purchase is something you can comfortably afford while staying within your means.
Don’t wait until something bad happens to take control of your financial health. Do what you can do now to ensure a better future and financial freedom and success.