Here's How to Calculate Your Debt-to-Income Ratio
Why is it important? According to lenders, this financial factor is a measure of credit merit.
No one ever plans on going into debt, but whether you're starting a new businesses, had to take out student loans, or are trying to pay your mortgage while juggling other bills, sometimes accumulating some level of debt is inevitable. In order to pay down your accumulated debt, understanding your debt-to-income ratio is a valuable piece of financial knowledge.
We asked Stanley J. Kon, Ph.D. and chairman of Ripsaw LLC, speak on this topic. "The debt-to-income ratio (DTI) is a measure of creditworthiness that, in conjunction with a credit score, gives lenders a sense of a potential borrower's ability to make their scheduled payments," explains Kon. "The higher the ratio, the riskier the loan to the lender." Lenders will say the ideal front-end ratio should be no more than 28 percent and the back-end ratio should be 36 percent or lower. Kon encourages people to maintain a DTI of 25 percent or lower, if possible.
So, how do you calculate your DTI on your own? Basically, your personal DTI is the percentage of your gross monthly income pre-taxes—add up all of your monthly debt payments, then divide by your gross monthly income. This goes toward payments for mortgages, rent, credits, and other debt. For example, if you pay $1,275 a month for your mortgage and another $300 a month for an auto loan and $125 a month for the rest of your debts, your monthly debt payments are $1,500. ($1,275 + $100 + $125 = $1,500.) If your gross monthly income is $6,000, then your debt-to-income ratio would be 25 percent ($1,500 is about 25 percent of $6,000)—which is the ideal, as Kon explains.
Understanding your DTI, and then working hard to stay within that favorable range, will ensure you remain in good financial standing and that you'll look like a strong possible borrower to financial institutions.