How to Calculate Your Debt-to-Income Ratio

This is a very important concept that anyone attempting to repair their credit needs to understand. When an individual is dealing with their credit, they need to look at their debt-to-income ratio, to see just how badly they are in debt, or how well they are doing out of debt.

The debt-to-income ratio is the percentage of an individual's monthly gross income that goes towards paying off their debts. This debt comes in two main forms.

The first form is the front ratio of the debt- to-income ratio, which shows the percentage of the income that goes towards housing costs, like a mortgage, or for renters, their rent. This calculation includes the mortgage principal, interest, mortgage insurance, hazard insurance on the mortgaged house, property taxes and even homeowner association dues.

The second form of debt-to-income ratio is the back ratio, which is the debt payments that go to recurring debt payments, including those in the front ratio, plus credit card debts, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments.

Why Does It Matter?

The reason this is so important is because many lenders will look at an individual's ability to pay back their debt based on how much debt they are currently paying off, which plays into the debt-to-income ratio.

For example, many mortgage companies will want an individual to have a debt-to-income ratio of about 28/36. This means the following:

If the individual has a yearly gross income of $45,000, and that is divided by 12: It comes to $3,750 per monthly income. Taking .28, we will learn that the front ratio for housing expenses will be $1,050 for the individual, which is what they can afford just on housing expenses. For the back ratio, it will come to $1,350 for housing expenses and recurring debt.

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This shows the mortgage company that the individual only has $1,350 for their housing expenses and recurring debt given the mortgage, available. This is not bad, but you want your debt-to-income ratio to be even smaller.

The reason for this is that the less you have to pay back each month on your debts, the more money you will have to pay for a loan, which means the better the ability you will have to pay back loans without allowing them to go into default.

How Do You Lower It?

This is the crucial piece of the puzzle that people need to figure out. Obviously, lowering it means you have to lower your debt, and that comes down to being responsible with your debt.

When someone has a high debt-to-income ratio, people will not want to lend to them for the obvious reasons that they are not safe to lend to. They will cite the fact that they already pay back a lot of on their income and there is no reason that they should incur more debt.

Another great way to decrease your debt ratio is to increase your income, but this is often easier said than done.

Lowering it can be done when you pay off your credit cards, so there is little or nothing on your credit cards. As well, you should try and pay off any loans that you may have at the time. This will help lower the debt-to-income ratio as well.

What Is The Best Ratio

The best ratio to have is something below 20 percent. This means that you have a lot of money available to pay on your debts, and your lenders will be more eager to lend money to you. However, that being said, it can be hard to have a debt-to-income ratio that is that low. So, try and have one that is at least below 36 percent. Most mortgage lenders, and other lenders, will still lend to you when you have a debt-to-income ratio that is lower than 36 percent.

What Is The Worst Ratio

The worst debt to income ratio that an individual can have, will be one that is above 46 percent. This is because they are paying nearly half, or more, of their income to their debts, and there is no way they will be able to incur even more debt. Doing so would threaten a default on the loan for the lender and they will not risk that.