You can calculate your debt-to-income ratio by comparing the amount of money you owe and how much you make. It’s also known as the DTI ratio. Debt includes all mortgages, credit cards, student loans, car loans, and any other loan that you may have taken out to purchase items for your home or pay for college.
In contrast, the income typically comes from a job or investment sources such as stocks and bonds. Too high a DTI ratio makes it difficult to qualify for new loans or get approved for a mortgage. This is because lenders want to know if you’re able to repay what you borrow with some leftover each month after covering expenses such as housing costs and food.
What Makes Up A Debt to Income Ratio?
The DTI ratio is expressed as a percentage. For instance, if your income equals $36,000 and you owe around $14,900 in loans, then the DTI ratio would be 37% ($14,900/$36,000).
Now that we know what debt to income ratios are, it’s time to delve into how they work with mortgages and investments. Let’s assume an individual has a mortgage of $200K on his or her house where he or she makes monthly payments of about $1500 per month.
The DTI for this person would be 13%. Now let’s say our friend wants to invest money but doesn’t want to put too much at risk, so he only invests ten thousand dollars.
That investment would have a DTI of about 45%. Now let’s say we want to buy an investment property that will cost $400,000, and for the sake of this example, it’ll require financing with a down payment of 20% or $80K.
The monthly payments on our mortgage loan are going to be around $2000 per month, so in order not to exceed 60% DTI ratio. We’re limited as to how much more money we can borrow from other sources, such as home equity lines typically capped at 80% LTV.
Two Different Kinds of Debt to Income Ratios
There are two different kinds of debt-to-income ratios. One is the DTI for an individual and can be calculated by dividing total monthly debt payments, including credit cards, car loans, or anything with a due date given on it, such as utilities, by gross income earned from all sources.
The other type of ratio used when calculating DTI levels is called the front-end ratio, which looks at how much people should spend on housing expenses versus their gross monthly income. For example, if your household makes $50K per year in take-home pay, you should not exceed spending 30% of this amount towards mortgage costs plus property taxes and insurance (note: many experts say 20% would be more reasonable).
What is Considered a Good Debt-To-Income Ratio?
The DTI ratio that many experts recommend is 36%. This would mean monthly debt payments should not exceed $900 as a percentage of gross income. Suppose you have an individual who makes $50K per year. In that case, this means they can afford to make up to about $4500 in monthly debt payments before they start moving into dangerous territory and possibly endangering their credit score.
What Is The DTI Ratio For A Home?
A good rule of thumb for calculating the maximum amount someone could borrow on a home loan (assuming 20% down) using your net annual salary is to multiply it x .28 = max mortgage payment in dollars. So if you earn 100k annually, then 28×100= $2800, so the max mortgage payment would be $2200.
Some advice on how to improve your debt-to-income ratio would be to make more money each year to increase your income and pay off your debts.
If you are a homeowner, your mortgage is likely the largest monthly debt payment. There’s no magic formula that will help improve your ratio unless you make more money or decide to stop making any payments on other debts. However, what can be done is work with lenders and credit card companies to see if they would lower interest rates for deferred periods as an incentive to pay off balances quicker.
If this doesn’t sound like it’s worth doing (it might not be), then find ways to reduce living expenses and save up some cash so that there’s something left over after paying what needs to be paid a month in case of emergency.
You could also refinance your home loan into one where the interest rate jumps back up once you’ve paid the principal down to a certain level.
Or, if you’re brave enough, consider using part of your home equity to invest in something with higher returns than interest rates on savings accounts or CDs.
Diversify and make sure any investments are low-risk so that one mistake can’t turn into an emergency, cashing out what’s left of your house for cash.