We all have a sense that more income and less debt are both good things. But what’s the ideal ratio between income and debt? If your debt-to-income ratio is too high, any shock to your income could leave you with unsustainable levels of debt. Avoiding debt altogether has drawbacks, too (consider no-fee credit cards and secured credit cards if you are scared of digging yourself in debt). Let us break it down for you with our guide to the debt-to-income ratio.
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The Debt-to-Income Ratio Defined
You know how it works. Every month you figure out the money you have coming in and the money you owe. There are your recurring bills for things like your cell phone and internet. There’s your regular spending on groceries and transportation. Then, there’s the money you spend to service your debt. That could be your mortgage, auto loan, student loans, personal loan or credit card debt.
Are there months when you feel like all your money goes to making payments on your debt? It sounds like you may have a high debt-to-income ratio (DTI) on your hands. The debt-to-income ratio is a number that expresses the relationship between your total monthly debt and your gross monthly income. Here’s the formula:
DTI = total monthly debt payments/gross monthly income
Say you pay $1,600 a month on your mortgage. You pay $400 a month for your student loans and have no other debt. Your total monthly debt payments come to $2,000. Your gross monthly income is the money you earn before taxes and deductions. If that’s $6,000, your DTI is 33%.
Why the Debt-to-Income Ratio is Important
From your perspective, the debt-to-income ratio is an important number to keep an eye on. That’s because it tells you a lot about how precarious your financial situation is. If your debt is, say, 60% of your income, any hit to your income will leave you scrambling. If you have to step up your spending in other areas (medical expenses, for example), you’ll have a harder time keeping up with your debt payments than someone with a DTI of 25%.
From the perspective of creditors and lenders, the DTI is an important measure of risk. Folks with higher debt-to-income ratios are more likely to default on their mortgages and other debt. When you apply for a mortgage, calculating your DTI will be part of the mortgage underwriting process. In general, 43% is the highest DTI you can have and still get a Qualified Mortgage. You want a Qualified Mortgage because it comes with more borrower protections, such as limits on fees.
What’s a Good Debt-to-Income Ratio?
If 43% is the maximum debt-to-income ratio you can have while still meeting the requirements for a Qualified Mortgage, what counts as a good debt-to-income ratio? Generally the answer is: a ratio at or below 36%. The 36% Rule states that your DTI should never pass 36%. A DTI of 36% gives you more wiggle room than a DTI of 43%, leaving you less vulnerable to changes in your income and expenses. Of course, if you can manage your finances in such a way that your DTI is, say, 18%, so much the better.
The debt-to-income ratio is an important measure of your financial security. The lower it is, the more affordable your debts are. With a low DTI, you can likely better weather storms and take risks. If you want to take a job that pays less but is in a field you’ve always dreamed about joining, you won’t have to worry as much about adjusting to a lower income. Plus, debt = stress. The higher your DTI, the more you can start to feel like you’re on a treadmill, working just to pay off your creditors. No one wants that.
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