Good salary, a good credit score, and good repayment history is a recipe for good financial health, right? Not so fast – there is a fourth important factor: your debt to income ratio (DTI). Lenders use this ratio to determine what percent of a borrower’s gross monthly income goes towards paying debts. This number greenlights a borrower’s eligibility and dictates how much money they may borrow. Regardless of all other indicators of financial health, if 36% or more of your income is spent repaying debts, your borrowing options may become limited and expensive.
Case in point: Recent changes to federal laws essentially prohibits mortgage lenders from approving loans for prospective home buyers whose total monthly debt exceeds 43 percent of their monthly gross income. Phil Denfeld, a vice president at First Heritage Mortgage recently ran the numbers for the Washington Post, “Take someone seeking a $626,000 loan with a 4.5 percent interest rate to buy an $800,000 house. If that person earned $125,000 a year and had a $450-a-month car payment, he or she would fall within the limit. But add a $100 student loan payment to the mix, and the debt-to-income ratio would climb above the restriction.”
What is a Good Debt to Income Ratio?
Unlike your credit score, calculating your debt to income ratio is simple. Add up the total cost of minimum monthly payments on all your recurring debts (car loans, rent, student loans, credit card debt, and any other loans that you might have), divide that number by your gross monthly income, multiply it by 100 and voilà, that number is the percent of income that you spend on debt.
Playing with the numbers a bit will illustrate how something as small as a $100 more in monthly rent or reducing your revolving debt by a few percentage points impacts your DTI. The difference between a debt to income ratio of 25% and 30% can be thousands of dollars in interest.
How to Improve Your Debt to Income Ratio
There are two ways to improve your debt to income ratio: increase your income or decrease your debt. Ideally you are able to do both over time, but that’s far easier said than done. If your DTI is being inflated due to student loans and credit card debt, you might be paying 20% or more in interest, refinancing that amount would make a significant difference in your total debt obligation. Consolidating your debt enables you to pay down debts with a higher interest rate by rolling them into a lower-interest rate loan, which lowers your monthly debt payments and enables you to pay off your debt more aggressively.
As you make choices that affect your income stream and debt load, keep this number in mind and update it accordingly. If you only keep track of two personal finance metrics, they should be your credit score and debt to income ratio.