Whenever you are trying to get a loan, the lender will evaluate your financial health. The lender performs this evaluation for many reasons, but it mostly comes down to their desire to cover their liability. In other words, they want to make sure that you will be able to pay them back. If you are not heavily in debt or behind on your bills, you might think that you don’t have any reason to worry. However, your situation might not be as safe as you think. Before you try to get a loan of any kind, you should take the time to calculate your debt-to-income ratio.
What Is Debt-To-Income Ratio?
Your debt-to-income ratio is a way to measure how much money you make against how much money you owe. You usually calculate it monthly, measuring your entire month’s income against all debts and bills that are due within that month. So, why do lenders care so much about this factor?
Lenders care a lot about your debt-to-income ratio because it is the best way to measure your financial health. They could judge it by income alone, but that would be foolish. It doesn’t do you any good to make a lot of money if your debts are even greater than your paychecks. Likewise, a person who owes more money than they earn is unlikely to pay their debts.
Step One: Add Up All Your Debts
To find your debt-to-income ratio, we will start with an accounting of all your debts. On a piece of paper, list all your debts in order from largest to smallest. Break out your financial records so that you can verify the exact amounts. If you did not keep those debt records (or if they have been lost), you would need to call the debt holder and get those numbers. This number should include both interest and principal payments, as both are part of the same debt.
Now, figure out your minimum monthly payment for all of these debts. By getting that payment lowered as much as possible, you can positively affect your debt-to-income ratio. Of course, your lender is unlikely to give you a lower rate unless you have maintained good faith with them. Just remember that your debt-to-income ratio is determined by your monthly debt payments and not by the total amount owed.
When you are adding up your debts, you don’t have to include costs like food costs, transportation, electric bills, water bills, and most types of insurance. These are not considered to be “debts” unless you let those bills get too far behind. Once it’s turned over to a collection agency, it will be considered as a part of your total debt and factored into your ratio.
Step Two: Add Up Your Total Income
Now it’s time for the less depressing aspect of the job. Figure out how much money you make each month, and write that number down on the same page as your debt numbers. Remember that you are using your gross income, which is your total income before taxes. Taxes are not factored into your debt-to-income ratio unless you have a serious tax delinquency problem.
If you have a typical job with a W-2 form, it should be quite easy to find your monthly income. First, take your weekly income and divide it by 7. This number will tell you how much money you make each day. Naturally, this will be an approximate figure, but it should be fine for what we need. For instance, let’s say you make $500 a week. 500 divided by 7 comes out to roughly $71.42 per day. Now, multiply that by the number of days in the month, and you will have an accurate estimate of your monthly income.
If you are an independent or freelance worker, make sure that you always save your receipts and any other relevant financial documents. If it pertains to your money in any way, don’t throw it away! These records will represent your only reliable way to determine your average monthly income. Make sure that you include all sources of income regardless of their nature.
Step Three: The Easy Part
Now that you have determined your total monthly debt, and your total monthly income, you have to apply a little bit of math. Take your monthly debt and divide it by your monthly income. For instance, let’s say your total monthly debt is $2000, and your total monthly income is $4000. 2000 divided by 4000 equals 0.5, which translates to 50% debt. This ratio would be too high for most lenders. If you don’t feel like doing the math yourself, you could always use this handy online calculator.
What Is Considered To Be A Good Ratio?
A lower debt-to-income ratio is preferred. However, each lender will have their own set of rules. For example, we might look at Fannie Mae’s rules on the subject.
For this lender, 36% is the highest debt-to-income ratio that they will consider for a loan. In some cases, they will make exceptions and accept a borrower with a ratio as high as 46%. However, this kind of leeway is only given to those with high credit scores and plenty of money in reserve. If your ratio is any higher than 46%, you might as well not bother trying to get a loan.
Once you have all of your records together, it is not hard to calculate your debt-to-income ratio. In many cases, it is also not that hard to lower your ratio. For those who are dealing with a debt-to-income ratio problem, you might try working out some different terms with your lender. They may not be willing to negotiate, but it’s certainly worth a try. If lender negotiations fail, you will have to either increase your monthly income or pay off some of your debt. While this is just a simple overview of the topic, we hope that it has taught you something about this crucial metric. If so, we invite you to fill out the contact form below for more great information.