• Adulting Is Easy (Lauren)

What is the Debt-to-Income ratio?

Debt-to-Income Ratio Definition


The debt-income ratio (DTI) is exactly what it sounds like. It is calculated by adding up all monthly debt payments and dividing by gross monthly income.


Debt-to-Income Ratio Application


Lenders calculate a loan seeker’s DTI to evaluate their ability to repay any additional loans. You will often hear about DTI when applying for a mortgage, and lenders prefer to see no more than a 36% DTI, with only 28% going towards the housing payment. Some lenders will consider approving a loan if the applicant has a DTI up to 43%.


Calculating Debt-to-Income Ratio


Step 1: Add up your debt payments, which include:

  • Car payment

  • Student loan payment

  • Rent/mortgage (including escrowed tax and insurance payments)

  • Credit card payments (minimum)

  • Personal loan payments

  • Child support and alimony

·Note: the following are NOT included in the debt-to-income calculation:

  • Monthly utilities (water, garbage, electricity, or gas bills)

  • Car Insurance

  • Cable bills

  • Cell phone bills

  • Health Insurance costs

  • Groceries/food or entertainment expenses

Step 2: Add up your gross (pre-tax) income, which includes:

  • Hourly wages

  • Salary

  • Tips

  • Bonuses & commissions

  • Pension

  • Social security

  • Child support and alimony

  • Side hustle income (if verifiable form tax returns)

  • Disability income

  • Income from investments

Step 3: Divide your total debt payments by your total gross income


An Example Case Study


Andrew has a student loan payment of $250 and a car payment of $300. He does not carry a balance on his credit cards, nor does he pay alimony or child support (because he has no ex-wife or kids). He has never taken out a personal loan. Andrew pays a monthly health insurance premium. He also pays for his utilities and cell phone. Remember, health insurance, utilities, and cell phone payments are not included in this calculation. He makes $48,000 per year in salary from his 9-5 job and $5,400 doing his side hustle.


Andrew is considering putting 10% down on a $200,000 house, which would make his payment about $1,300, including principal, interest, insurance, taxes, and private mortgage insurance.


He knows a potential lender will take the following steps to calculate his DTI, so he calculates it himself:


Monthly debt payments, including the proposed mortgage payment:

  • Student loan payment: $250

  • Car payment: $300

  • House payment: $1,300

  • Total: $1,850

Gross income:

  • Salary: $48,000

  • Side hustle: $5,400

  • Total: $53,400

  • Monthly: $4,450

Overall debt-to-income Ratio: $1,850/$4,450 = 41.6%

Housing DTI: $1,300/$4,450 = 29.2%


There is a chance Andrew would be approved, since some lenders will accept up to a total 43% DTI. He knows he would be better served to have a DTI below 36% and a housing DTI below 28%. He can accomplish this by lowering his debt payments and/or increasing his gross income:

  • Andrew could pay off his student loans.

  • He could pay off his car.

  • Andrew could look at buying a cheaper house.

  • He could make a bigger down payment on the house.

  • Andrew could ask for a raise at work (based on merit and accomplishments, not his desire to buy a house)

  • He could do more work at his side hustle.

Andrew only has enough cash to either pay off one of his existing loans (student or car) OR buy a house. He would rather keep the existing loans as they are and buy the house, and he wonders what his DTI would be if over the next year he scored a 5% raise in salary, made an additional $3,000 at his side hustle, and put aside enough cash for a 20% down payment on a $180,000 home. The new proposed housing payment would be $1,100.


Andrew’s DTI after one year would be:


Monthly debt payments, including the proposed mortgage payment:

  • Student loan payment: $250

  • Car payment: $300

  • House payment: $1,100

  • Total: $1,650

Gross income:

  • Salary: $50,400

  • Side hustle: $8,400

  • Total: $58,800

  • Monthly: $4,900

Overall debt-to-income Ratio: $1,650/$4,900 = 33.7%

Housing DTI: $1,100/$4,900 = 22.4%


If Andrew takes those proposed steps, he will be well within the 36% total debt-to-income and 28% housing debt-to-income guidelines lenders look at when approving loans. He sets to work at his side hustle and sets a performance review meeting with his boss.





Sources:

Investopedia

Consumerfinance.gov

Well Fargo

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