Do You Know Your Debt-to-income Ratio? Your Lender Does...
Ever wondered how a lender determines just how much they’re willing to lend you? When it comes to purchasing a new home or vehicle, the amount that you’re able to finance will ultimately determine where you live and what you drive — these have major lifestyle implications. The amount of debt you’re able to take on, and still comfortably make monthly payments, has a major effect on your day-to-day routine. It’s important to understand what you have and what you can afford.
When it comes to taking on a major loan — particularly for a home — your credit score is a driving factor. It’s based on multiple elements like length of credit history, payment history, and amount owed. After your credit “worthiness” has been established, it then goes by what you can reasonably afford. Affordability is largely determined by your debt-to-income ratio, or your DTI.
Your DTI is based on a simple formula: monthly gross debt divided by monthly gross income. For example, if your gross income is $3,000, and you pay $1,500 in monthly bills, your debt-to-income ratio is .50, or 50%.
Keep in mind that monthly gross debt refers to your recurring monthly debt — minimum payments due for things like your vehicle, credit cards, cell phone, and student loans. Monthly grocery bills and restaurant tabs aren’t included in your DTI. Simple, right?
Lenders realize that in the real world, people do have expenditures outside of recurring monthly bills — food, fuel, entertainment, and the like. Because of this, lenders set the magic number at 43. A 43% debt-to-income ratio, for most conventional loans, is the highest ratio that a borrower can have and still be granted a qualified mortgage. If more than 43% of your monthly income is tied up in recurring bills, lenders will likely not be willing to grant you a mortgage.
So where do you stand as a borrower? Sit down and look at your monthly income after taxes. Then, figure out your monthly recurring bills. Calculate your DTI and take a meaningful look at your ratio. If you’re over 43%, it’s time to sit down and start devising a plan. Consider credit consolidation or eliminating unnecessary expenditures (like that gym membership or steak-of-the-month club…). Get your ducks in a row, know your credit score and your DTI, and go into your next big purchase with confidence and awareness.