Meaning and definition of Debt-to-Income Ratio
The debt-to-income ratio can be expressed as a personal finance measure that is helpful in comparing an individual’s debt payments to the income generated by him/her. This measure is important in the lending industry for it provides the lenders with an idea about the possibilities of the borrower repaying the loan. As explained by the Investopedia, a higher debt-to-income ratio indicates more burden on the individual for making payments on his/her debts. Besides, if the ratio is too high, the individual will experience a hard time accessing other forms of financing.
Importance of Debt-to-Income Ratio
It is really important to know about what the debt-to-income ratio number indicates. Apparently, this is a number that needs to be as low as possible. The less debt relative to the income indicates an individual being financially better off because of having extra money to apply towards other goals.
When it comes to mortgages, the lenders tend to look at two key debt-to-income ratios. First, they consider the front ratio, which is the debt to income ratio consisting of all housing costs. Then, there is the back ratio, which considers the non-mortgage debt to income ratio. Usually, the lenders prefer a front ratio of 36% or less and a back ratio of 28% or less.
Calculating the Debt to Income ratio
Calculating the debt-to-income ratio is as simple as toting up all of your debt and deducting it from your income. Some calculations might exclude items like mortgage payments and property taxes, but to actually get a complete picture, it is better to include everything.
As the first step of calculation, congregate all of your monthly debt obligations. This will include monthly payments like:
- Car payments
- Mortgage payments
- Student loans payments
- Minimum credit card payments
- Child support
- Any other monthly debt obligations
After adding these all up, you will get the total monthly debt payments. Thereafter, calculate your monthly income counting your monthly salary and additional bonuses (if any). Then add up any additional income received through dividends, or a side business. Add up all these to get your monthly income.
As a final step, determine the debt-to-income ratio by dividing the total debt payments by total monthly income.