What Is Debt to Income Ratio?
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.
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.
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.