Your debt-to-income ratio is generally calculated as how much of a percentage your monthly debt burden is compared to your gross income. Lenders may use this ratio as a way to gauge your financial burdens when they're deciding if you're a good candidate for loans such as mortgages. It can also give you a picture of where you stand in terms of your financial strengths, giving you a summary of your portfolio and potentially identifying where you can improve. The idea of what's best for a debt-to-income ratio varies depending on the specific situation.
When you're applying for a mortgage, your mortgage broker will generally use your debt-to-income ratio to assess the risk you pose in terms of defaulting on your commitment, and therefore your eligibility and interest rates. While specifics vary by lender, you'll generally get the best mortgage rate if your monthly debt doesn't surpass 38 percent of your gross income. However, some lenders may be more forgiving. For example, financially struggling individuals who apply for a mortgage through the Federal Housing Administration have more leeway and can possess a debt-to-income ratio of up to 43 percent.
Home Equity Loans
A loan taken out on the equity of your real estate investments can give you a huge credit pool to tap into. When applying for such a loan, the lender generally looks at a narrower debt-to-income ratio that focuses on your future loan amount against the value of your home. Typically, most homeowners can't take out debt on their home value that exceeds 80 percent of the home's value, but you may only be able to squeeze 60 percent out of your equity in cities with struggling housing markets.
When you're applying for a line of credit that takes into account your credit score, the credit bureaus calculate your score by creating a debt-to-income ratio that focuses just on your credit utilization against your total credit available. For the ultimate boost in your score, credit bureaus typically suggest spending only 10 to 20 percent of your total credit limit.
Many people graduate from university with significant educational loans, and this can affect their future financial portfolios and growth potential for decades. The "Kiplinger" financial magazine notes that the median educational loan burden was approximately 8 percent of the individual's monthly income. The magazine notes that borrowers whose educational loan payments comprised 7 percent or more of their income experience the greatest financial burden, while those who had a ratio of 7 percent or less of their gross income experience few, if any, financial difficulties. Thus, if you're in the 7 percent or lower category, you may consider yourself as doing well.
- CNNMoney.com: How Much Home Can You Afford?
- "Entrepreneur"; Opportunity Knocks; Carolyn Brown; February 2009
- "Kiplinger"; What It Takes to Get a Loan; Jessica Anderson, et al.; November 2010
- CNBC.com: In Search of the Perfect Credit Score
- "Kiplinger"; Keeping College Debt Under Control; Janet Bodnar; September 2008
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Debt ratio, also called debt-to-income ratio, compares your gross monthly income, or income before deductions, to your total monthly debt load.