Your debt-to-income ratio, or debt ratio, is typically represented as the percentage of your income that goes toward paying your debt. A lot of lenders, especially mortgage and auto lenders, use your debt ratio to evaluate your credit worthiness, i.e., how much of a loan you can handle. For example, a mortgage lender will use your debt ratio to figure out the mortgage payment you can afford after your other monthly debts are paid. Debt ratio considerations are as important as your credit score. While your credit score reflects how responsible you are in paying your bills, your debt ratio gives potential creditors additional insight into your personal finances. Your debt ratio shows just how much debt you're juggling as compared to your income. It's possible that someone with a good credit score could be turned down for a mortgage or home loan because lenders feel the borrower is simply carrying too much debt, despite a steady history of on-time payments.
Information Needed To Calculate Debt Ratio
- Gather recent paycheck stubs. Add up total gross monthly income. If total income varies from month to month, calculate the monthly average for the past two years.
- Determine the total housing cost, such as mortgage principal and interest or apartment rental, mortgage insurance premium, property tax, homeowner's insurance premium, hazard insurance premium, and any homeowner's association dues.
- Gather statements from all other monthly recurring bills. This includes revolving debts (the minimum monthly credit card payments listed on the credit report), installment loan payments (including such things as vehicle loan or lease payments and student loan repayments), alimony payments, legal judgments, etc. Any installment debt with fewer than ten payments remaining is not to be counted unless it is a vehicle lease payment; lenders believe another vehicle lease agreement will be signed when the current lease expires.
- Add the amounts from these other monthly recurring bills to the total monthly housing cost to calculate the total monthly debt obligation. Do not include ongoing living expenses such as groceries, gas, or utilities, as these are not considered debts.
Let's go through an example to demonstrate how to calculate debt ratio. Assume the following monthly financial situation for an applicant:
- Gross wages of $5,000
- Principal and interest payment of $1,000
- Property tax of $150
- Homeowner's insurance of $65
- Homeowner's association fees of $45
- Total credit card debt of $225
- Vehicle loan payment of $350
- Student loan repayment of $125
Now we are ready to calculate the debt ratios.
There are two different debt ratios which mortgage lenders use when evaluating a borrower for a loan.
Primary Debt Ratio
The primary or front-end ratio is the monthly housing cost divided by gross monthly income.
In this example, the total housing cost is $1,260 ($1,000 + $150 + $65 + $45 = $1,260).
Gross monthly income is $5,000.
The primary or front-end debt ratio is 25.2% ($1,260 / $5,000 = 25.2%).
Secondary Debt Ratio
The secondary or back-end debt ratio is the total of all recurring monthly debt (housing cost plus all other monthly recurring debt) divided by gross monthly income.
In this example, the total recurring monthly debt is $1,960 ($1,260 + $225 + $350 + $125 = $1,960).
The secondary or back-end ratio is 39.2% ($1,960 / $5,000 = 39.2%)
Lenders like these ratios to be low – generally, the lower they are, the greater the chance you will be able to get the loans or credit you seek. Talk to your lending professional about the debt ratio requirements for the type of loan for which you’re applying. If your ratios are higher, you should take action to reduce them.
Finally, lenders have policies in place on how to calculate income, so be sure to speak with your lending professional to determine what monthly income figure they’ll use.