Two major components of tracking how you’re doing financially can be broken down into your income and debt levels. Obviously, you’d like to have more income coming in than debt payments going out, but even if you are making more money than you owe, how can you tell if that’s good enough? That’s where the debt to income ratio can come in handy. This quick calculation can give you an idea of where you stand and can be helpful in helping you with other financial decisions such as figuring out how much money you can borrow to buy a house.
Ratios as a Financial Litmus Test
Financial ratios don’t give you a terribly detailed picture of your financial situation, but they can be used to quickly gauge how you’re doing. In addition to the debt to income ratio, another easy ratio to calculate is your net worth. With net worth you’re essentially adding up all of your assets and measuring them against all of your liabilities. A positive number means you have more assets than liabilities while a negative number means you have more liabilities than assets. This number can help you track your financial progress from year to year.
Not only is the net worth calculation useful, but your debt to income ratio can come in very handy. In fact, it’s even used by many lenders to determine whether or not to extend financing if you’re requesting a loan. If you have a head start and already know what your debt to income ratio is, you’ll be better prepared to find the loan that’s right for you.
Calculating Your Debt to Income Ratio
Calculating your debt to income ratio is as simple as adding up all of your debt and subtracting it from your income. Some calculations may exclude things like mortgage payments and property taxes, but to really get a complete picture it’s best to include everything.
So, to get started, take a moment to gather all of your monthly debt obligations. This will include monthly payments such as:
- Mortgage payment (including taxes, insurance, private mortgage insurance, etc.)
- Car payment
- Minimum credit card payment
- Student loans payment
- Child support
- Any other monthly debt obligations
When you add these all up it will give you your total monthly debt payments. Keep this number handy as we’ll be using it in just a minute.
Next, you need to calculate your monthly income. Start with your monthly salary. If you receive any additional bonuses on a yearly or quarterly basis, be sure to divide it out to get the per month number. Finally, add up any additional income you receive, whether through dividends, a side business, or whatever the case may be. Total these all up and you will have your total monthly income.
Now comes the easy part. To determine your debt to income ratio simply take your total debt payment number and divide it by your total monthly income. That equals your debt to income ratio. For example, if you came up with a $2,000 total debt payment number and monthly income of $6,000, that leaves you with a debt to income ratio of 33%.
Why Debt to Income is Important
So you’ve calculated your debt to income ratio, but what does that number mean? Obviously, this is a number you want to be as low as possible. The less debt you have relative to your income, the better off you are financially since you have extra money to apply toward other goals. But it’s also important in terms of deciding how much of a house you can afford.
Lenders tend to look at two key debt to income ratios when it comes to mortgages. First, they look at the front ratio, which is the debt to income ratio that includes all housing costs. Then, there is the back ratio, which looks at your non-mortgage debt to income ratio. Generally speaking, lenders would like to see your front ratio at 36% or less and your back ratio at 28% or less.
Keep in mind that these ratios are only guidelines and there are many other factors that go into determining how much you can borrow and at what rate. But if you want to have a general idea of what’s to be expected, you can play with these numbers to see where you stand and how you can improve your situation.