Q) How do you calculate your debt-to-income ratio?
A) The question that Debt-to-Income Ratio answers is: 'Is my total debt burden too high?'
To calculate your debt-to-income (DTI) ratio, you must determine two fundamental values: your total monthly debt payments and gross monthly income.
Here's how you can calculate your DTI ratio ( debt to income ratio ) :
Calculate your total annual debt repayments: Add up all your yearly debt obligations. Which typically includes: Mortgage or rent payment ( monthly x 12 ) Minimum credit card payments Car loan or lease payments Student loan payments Personal loan payments Alimony or child support payments Other monthly debts or obligations
Calculate your annual gross income: Determine your total yearly gross income, which is your income before taxes and deductions. Which may include doing the best you can to estimate: Salary or wages Self-employment income Rental income Investments or dividends Social Security benefits Alimony or child support received Any other regular sources of income
Divide your total yearly debt payments by your gross income: Divide your total annual debt payments by your gross yearly income, and then multiply the result by 100 to get your DTI ratio as a percentage.
Formula: DTI Ratio = (Total Annual Debt Payments / Gross Annual Income) x 100
Example: If your total annual debt repayments are $18,000 and your annual gross income is $60,000, the calculation would be:
DTI Ratio = ($18,000 / $60,000) x 100 = 30%
In this example, your DTI ratio is 30%, which indicates that 30% of your gross monthly income is dedicated to debt payments.
Lenders typically prefer a lower debt to income ratio (DTI ratio), demonstrating that you have more disposable income to handle additional debt obligations, such as credit card bills and auto loans. Different lenders may have other maximum DTI requirements, but as a general guideline, a DTI ratio below 43% is favorable when applying for a mortgage. We feel this ratio (43%) is too high.
Financial Counselors will suggest that a Debt-to-Income of 36 or less is desirable. A lower ratio means reduced financial strain and greater funds available to pay off high-interest debts and save for future objectives, like retirement. By increasing savings and investments, you can expedite your path to retirement.
When considering taking on additional debt, such as a mortgage, think about what would happen if you lost your primary source of income. How long would it take to regain employment, for example? If couples qualify for a mortgage using the income of both partners, would the debt-to-income ratio be over 36 if one partner quits their job to stay home? Consider real-life events over the next 2 to 5 years when factoring in taking on more debt. Would buying a new home be good if your work required you to move next year?
In conclusion, while predicting the future is impossible, don't let your dream of home ownership or even an investment rental property keep you from moving forward with a mortgage. If you feel your Debt to Income Ratio is low enough that you will be able to sleep well at night, then move forward with action. Good luck on your decision. Let us know your thoughts in the comments below or by emailing us. Thank you, Spark Financial Wellness.
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