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How to Calculate Your Debt to Income Ratio: Explaining With Examples

written by: Olivia Emisar•edited by: Michele McDonough•updated: 7/23/2011

We all know that when we don't need the money, the banks are eager to lend it, but when we are in dire straights we can't get a loan to save our lives. It's not a coincidence, banks know our finances better than most of us do and if we are viewed as a risk, the chances of getting a loan are low.

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    What Is Debt to Income Ratio?

    Debt 

    Debt is calculated as a percentage of money owed in relation to the amount of income that comes in on a monthly basis. The categories of debt taken into account include revolving credit (credit cards), mortgage or rent payments, car and mortgage loans, property taxes and insurance premiums.

    There are two categories of Debt to Income ratios: One is called the front-end ratio and the other one is called the back-end ratio. The front-end deals primarily with the cost of housing (mortgage or rent), insurance premiums, home owner's association fees and property taxes.

    Example:

    Junior lives with his parents, has no recurring bills and has been saving up roughly 3/4 of his paycheck for the past five years. He feels that he is in a good position now to purchase a house of his own.

    We know that Junior saves most of his money, spends little every month on incidentals and his take home pay is $2,000 a month.

      Calculator To figure out Junior's qualifications in the same manner the bank would figure out his qualification, we need to know the formula used by banks to determine if Junior merits a mortgage loan or not.

      The traditional bank formula is 28/36 - This means that the monthly income is looked at in two ways to achieve the amount of payment to a loan and recurring debt Junior can manage based on his reported income.

      We multiply $2,000 by .28 and arrive at $560. This number, $560, is what the bank considers the amount available to Junior for housing expenses. This number must include mortgage, insurance, homeowner's association fees and property taxes. This first example is known as the front-end DTI ratio.

      Now we multiply $2,000 by .36 and we arrive at $720. This number, $720, is what the bank thinks Junior needs to have every month to meet recurring expenses and his mortgage obligations. This last number includes credit card payments, any student loans Junior is still repaying, auto loans and store credits. This last example is called the back-end DTI ratio.

      From the above example, Junior is actually doing very well since he has no other bills to pay. His monthly income qualifies him for mortage payments of $560 a month and he certainly has that.

      The lower the amount of debt and the higher the monthly income, the more other factors are impacted in a positive way, such as credit scores and the ability to obtain credit cards and loans with lower interest rates than people who have a higher amount of debt in relation to their income.

      To calculate your own DTI ratio, you must gather all your recurring expenses. Include child support and alimony payments, student loans, credit card payments, mortgage, home owner's association dues, property taxes and annual insurance payments. Add the total per year and divide it into 12.

      Next, add up the total of your annual income and divide it into 12 and use the example listed above to multiply your income by the 28/36 ratio. If your debt is lower than the figure the bank is looking for on the back-end ratio, you are in very good financial shape.

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      Does My DTI Ratio Matter?

      Credit Crunch The short answer is a resounding yes. Even if you already own your home, have not taken any loans in the past couple of years and are managing to make ends meet, there may come a time when you want to apply for a new credit card, take out a secure or unsecured loan to meet a pressing emergency or take a needed vacation. In order for you to secure a loan with a low interest rate, your DTI ratio will be looked at and so are the three magical numbers from the three major credit reporting agencies. FICO scores and credit scores make a huge impact on how the financial institutions determine our credit worthiness.

      Your payment history, length of time accounts have been opened, length of employment, timely payment history and your DTI ratio are all taken into consideration when these agencies calculate your credit worthiness. These numbers tell the bank what level of risk is associated with your purchasing and repayment habits and how stable you are financially. These numbers will weigh heavily in negotiating your interest rates and ability to shop around for better options with different lending institutions.

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      Calculating your debt to income ratio may be frightening to people who sense they are not on great financial footing, but it is an essential tool to take control of your finances and be the one in charge of your life and lifestyle. Knowing your financial situation down to the penny empowers you to make better financial decisions that ultimately have a positive effect in your overall quality of life.

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      References

      U.S. News: Are You In Over Your Head?; http://www.usnews.com/usnews/biztech/tools/modebtratio.htm

      Real Estate ABC: How Much House Can You Afford?; http://www.realestateabc.com/loanguide/afford.htm

      Images: Credit Cruch by Grant Cochrane / FreeDigitalPhotos.net; Debt by krishnan / FreeDigitalPhotos.net; Calculator by nuchylee / FreeDigitalPhotos.net