Living Frugal
What is a Good Debt to Income Ratio?
Your debt to income ratio tells the story of your overall financial health. It's the overall percentage of your gross income (monthly) that you apply towards outstanding debts.
This number is just as important as your credit score. If you have an outstanding credit score but you have a high percentage of debt, you could get turned down for a loan.
Lenders want to see this number low, a maximum of 36 at the very highest.
Having a high amount of outstanding debts gives the impression that you live beyond your means. You may be paying your debts (as a high credit score would indicate) but missing one paycheck could turn your world upside down.
Having a lower percentage of debts in relation to your income is in your best interest when it comes to your personal finances as well as being approved for a loan.
Less debt is viewed as a good thing by lenders when evaluating your loan application. The higher the number, the less money you have left at the end of the month to take on another payment.
A good debt to income percentage is that you owe less than 28% of your monthly income. If you have a number of 40, you are likely struggling to have money left over at the end of the month.
If you're applying for a mortgage, a lender will use your gross monthly income to for the calculation. However, since you can't spend what you don't have, use your net income (take home pay) to do your personal calculation. This gives you a good picture of what you can really afford without struggling to make ends meet.
Debt to Income Ratio Uses
Not only is this number used by financial institutions when considering a loan application, it should also be used by you to determine what you can afford.
Let's look at some numbers so you can accurately gauge where you are with your finances.
- 36% or lower: You are carrying a balanced amount of debt while you aren't in over your head.
- 37% - 42%: You need to start a debt elimination plan before you get into trouble. You aren't having financial difficulties but missing one paycheck could wreck your finances.
- 43% - 49%: If you aren't already having financial troubles, they are just around the corner if you don't take action immediately to start reducing your debts.
- 50%: You need a professional to help you get control of your debts and start reducing them as aggressively as possible.
Mortgage Debt to Income Ratios
If you're thinking about buying a home and will be applying for a mortgage, find out what your mortgage debt to income percentage is.
In general, there are two different calculations that a mortgage lender will use. One is called a "front" while the other is called a "back". Each are ratios evaluating your income against your outstanding debts.
- The "front" ratio is calculated by taking your gross monthly income that will be allocated for your housing costs. These costs should include principal, taxes, insurance, homeowners association dues, loan interest.
- The "back" ratio is basically the same calculation but all your debts are included in this calculation. Debts such as car payments, credit card debts, student loans.....etc.
- An acceptable debt to income ratio is 33/38 (front=33, back=38).
Example Calculation
- If your gross annual salary is $50,000, you'll take $50,000 and multiply by 33% (50,000*.33)=$16,500.
- Your housing expenses in total should not exceed $16,500 per year or you are in over your head.
Now let's look at a "back" calculation that includes your outstanding debts.
- $50,000 annual salary
- $10,000 debts
- $40,000 multiply by 38% ($40,000*38)=$15,200. Your housing expenses should not exceed $15,200 per year.
FHA Debt To Income Ratio
The FHA debt to income percentage guidelines are 29/41 which gives you a little more breathing room on the "back" ratio and a little less on the "front".
When applying for a mortgage, these numbers can be flexible provided you have a large down payment. They also take your overall net worth into account when evaluating your mortgage application.
I have often heard of the number going as high as 50% providing you have a high FICO score and a substantial amount of liquid assets.
If you're in this number range, it is advisable to pay off a credit card with high payments so you can qualify for a lower rate mortgage.
In summary, watch your finances and don't take on more than you can afford. Planning for your financial future today secures financial independence tomorrow.
Debt to Income Ratio Calculator
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