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When a Lender wants to determine if a potential borrower has the financial ability to pay back a requested loan, they use a simple formula known as Debt-to-Income-Ratio or DTI.
This formula provides Lenders insight of a potential borrowers Personal Financial State and whether or not the person is in a stable financial position to acquire an additional monthly financial obligation.
To put it simply, it measures an individuals ability to meet the monthly payments on their debts when compared to the individuals gross income.
Debt-To-Income-Ratio is calculated to a percentage by simply dividing an individuals total recurring monthly debt by their total gross monthly income.
Total Recurring Monthly Debt includes:
- Mortgage Payments
- Auto Loans
- Child Support
- Credit Card Payments
- Insurance Payments
- Personal Bank or Credit Union Loans
- Student Loans
Total Gross Monthly Income
- This is the amount you earn each month BEFORE taxes and any other deductions are taken out of your paycheck
Study the following example:
John’s total recurring monthly debts include:
- $675 monthly mortgage payment
- $250 monthly auto loan payment
- $500 in total monthly credit card payments
TOTAL Monthly Recurring Debt equals: $1425
John’s Total Gross Monthly Income (BEFORE taxes or other deductions)
- $3000 per month
John’s Debt-to-Income-Ratio would be calculated by dividing his Total Monthly Recurring Debts, which are $1425, by his Total Gross Monthly Income, which is $3000, as follows:
- $1425 divided by $3000 equals 0.475 percent (or 48%)
POINT:
A LOW Debt-To-Income-Ratio number is a good sign of balance between debt and income.
A HIGH Debt-To-Income-Ratio number is an indication that an individual is carrying way too much debt when compared to their gross monthly income.
In general, a potential borrower may have a DTI number as high as 43% and still qualify for a mortgage loan, however, a DTI of 36% or lower is preferable with no more than 28% of the monthly recurring debt going towards the servicing of a mortgage loan.
Now just to be clear, these numbers are NOT hard and fast.
All Lenders have their own internal Debt-to-Income Ratio policies when it comes to approving a variety of of loans, but it would be safe to say that the lower the DTI number, the better chance a borrower has of getting approved for their selected loan.
Strategy:
There are two ways to lower the Debt-to-Income Ratio, or DTI number, and that is to either:
- reduce monthly recurring debt or
- increase gross monthly income
In the above example, John would most likely be denied any opportunity to get a loan approved because of his HIGH DTI number (48%), however, let’s say that John’s gross monthly income increases to $4000 and his monthly recurring debt stays the same.
Using the DTI formula, John would be in a much better position to get approved for a loan as his new DTI number is now 36%:
- $1425 monthly recurring debt divided by $4000 gross monthly income equals 0.3562 (or 36%).
Let’s say that John’s gross monthly income stays the same ($3000) but he finally pays off his auto loan, saving him $250 every month.
Well, this action would reduce his monthly recurring debt to $1175.
Now, John’s Debt-to-Income-Ratio has been lowered to 39% and by applying the DTI formula you can see how this works:
- $1175 monthly recurring debt divided by $3000 gross monthly income equals 0.3916 (or 39%).
If John was able to manage to do both, increase his income to $4000 and pay off his auto loan, he would definitely be in a much better Personal Financial State to acquire the loan that he seeks:
- $1175 monthly recurring debt divided by $4000 gross monthly income equals 0.2937 (or 29%).
I know, it’s math, and many people do not like math, and math can definitely make your head spin, however, it is very important that you understand the Debt-to-Income Ratio formula as it will help you sustain the best possible credit score.
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