What Is a Debt-to-Income Ratio of 50%?
A debt-to-income ratio is the percentage of monthly income that a borrower spends on debt repayment. Lenders use this ratio to determine if a borrower can afford to borrow additional funds. For example, many lenders set the debt-to-income ratio limit at 36 percent for mortgage loan approval. A debt-to-income ratio of 50 percent, meaning half of a borrower's monthly income is spent on debt, would be considered too high for a new loan.
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How Debt-to-Income is Calculated
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Lenders calculate debt-to-income ratio by dividing a borrower's total pre-tax monthly income by the total of all monthly debt payments. Debt payments include payments on credit cards, student loans, mortgages, car loans, lines of credit, judgments, liens and collections. Even if credit card balances are paid in full each month, the minimum monthly payment is included in the debt-to-income calculation.
Credit Report and W-2 Forms
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The borrower's credit report contains the information used in the debt-to-income calculation. Each credit bureau -- Equifax, Experian and TransUnion -- lists all debts owed by the borrower as well as the required monthly payment. To obtain the pre-tax monthly income, the lender either uses the borrower's most recent W-2 form or his last two tax returns. An average monthly income may be used in the event of a borrower with non-salary income.
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How to Lower Your Debt-to-Income Ratio
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Look for ways to pay off small debts or to consolidate several debts into one. Many times, if you consolidate several debts into one lump sum, the resulting monthly payment and overall interest expense is lower. To pay off small debts, use savings or earn additional income to use to quickly lower your monthly debt payments and your debt-to-income ratio all in one.
Credit Score
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Many times, a high debt-to-income ratio results in a lower credit score. If a borrower has a large amount of debt, the lines of credit are extended to their limits. The higher the balance of a debt is to its credit limit, the greater its negative impact on a credit score. Lowering your overall debt burden will have a lowering effect on your debt-to-income ratio and a positive effect on your credit score.
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References
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