Why Your Debt-to-Income Ratio Is Important
Your debt-to-income (DTI) ratio is a key measure of your financial health. It compares your monthly debts to monthly income and is used to see how well you can manage debts.
Spoiler alert: lots of debt is bad.
Calculating Your Debt-to-Income Ratio
Your DTI ratio is found by adding up all your monthly debt payments—such as a rent or mortgage, car loan, student loans, credit card bills, etc.—and dividing that amount by your gross monthly income. Your gross income is the money you make before taxes, deductions, and all'at are taken out.
For example, let's say that your mortgage is $1,000, car payment is $400, student loan payment is $300, and credit card payment is $300. If your monthly gross income is $4,000, your debt-to-income ratio would be 50%. You should work towards getting your ratio down to 20%, but of course, that's much easier said than done.
If you're new to the workforce and making [non-engineer or investment banking] entry-level money, this is probably as farfetched as finding a Prius without a Bernie Sanders bumper sticker on it.
Your first goal should be getting this amount below 40% because any amount higher than that is seen as a red flag. If a good portion of your paycheck is going to paying off debts, you're more likely to run into trouble trying to make your monthly payments.
How Lenders Use Your Debt-to-Income Ratio
Along with your credit report, lenders look at your debt-to-income ratio to determine your creditworthiness. Think about it: If you knew someone owed everybody East of the Mississippi money, wouldn't you be skeptical about loaning them more money? If not, you're just as foolish as a Black man that reaches for his wallet in front of the police.
The debt-to-income ratio requirements vary by lender and loan type, but generally speaking, smaller banks and personal loan providers accept higher ratios than big banks and lenders offering mortgages. It's much easier to take a risk on someone needing a $10,000 personal loan versus someone needing $250,000 for a mortgage.
When it's time to buy a crib and you need to get a mortgage, lenders will look at two components of your debt-to-income ratio: the front-end and back-end.
The front-end ratio, or housing ratio, is the percentage of your income that would go toward housing expenses—including homeowners insurance, property taxes, and all those other fees people don't consider before making those "Why pay $1,500 for rent when you can get a mortgage for $1,000" statements. The back-end ratio includes all of your monthly debts.
Usually, a debt-to-income ratio of 43% is the highest lenders will accept for a qualified mortgage—which is a loan that is structured to be more affordable. Like every rule—except the one about White folks not being able to say the n-word—there are exceptions. Smaller lenders may be able to offer qualified mortgages if your ratio is higher than 43%, but if you plan on walking into a Bank of America or Wells Fargo with a percentage higher than that, you might as well save your time and gas money.
While your debt-to-income ratio does not directly affect your credit score, they cross paths when it comes to credit utilization. Your credit utilization is the amount of credit you're using compared to the total amount you have available, and it makes up 30% of your credit score.
If a good amount of your debt is on credit cards, your credit utilization is likely higher than preferred. You want to try and keep your credit utilization below 30% to help your credit score. The lower, the better.