- I didn’t hear the term “debt-to-income ratio” until I was applying for a mortgage at 26.
- The ratio is one of the most important tools lenders use to decide how much money to give you.
- Understanding debt-to-income helped me grasp the huge impact of my student loans.
- I wish I had understood this term sooner, so that I could have made more informed decisions about student loans and other debt.
- Read more personal finance coverage.
When I was in my late teens and early 20s, I vowed to make different financial decisions than my parents had. When I got into a private college, my parents were unable to qualify for parental student loans because they had poor credit. I promised myself that I would maintain good credit, so I would have options open to me when I needed to borrow money.
I made my payments on time and resisted the urge to use all of my available credit. Because of this, I had a solid credit score in the high 600s throughout my early 20s. I was proud of myself for maintaining decent credit despite some financial challenges. However, while my focus was on building credit, there was another financial measurement I wasn’t paying no attention to: my debt-to-income ratio.
It wasn’t until I was applying for a mortgage at 26 that I learned about debt-to-income ratio, and how important it is for lending. If I had known about it sooner, I likely would have made different financial decisions, especially around my student loans.
What is a debt-to-income ratio?
Your debt-to-income ratio compares your monthly debt obligations to your monthly income. You calculate your ratio by adding up all your monthly debts (mortgage/rent, car payment, student loans, credit card minimum payments) and dividing that by your gross (pre-tax) income.
For example, consider that you owe $US2,500 in debt each month (which would be easy with a $US1,500 mortgage, a $US400 car payment, and a few student loans and credit cards). If you make $US5,000 a month (more than the American average), your debt-to-income ratio is 50% ($US2,500/$US5,000). This tells lenders that half of your money goes to debt payoff.
What’s a ‘good’ debt-to-income ratio?
As long as you’re paying off your bills, your ratio shouldn’t matter, right? Ha! That was always my mindset, and it turns out it’s far from the truth. You might feel good about the fact that “only” half your income is going toward debt, but lenders won’t.
Most lenders want your debt-to-income ratio to be 43% or below, according to the Consumer Financial Protection Bureau. Because of this cap, the amount of debt you have has a direct impact on the amount of financing you can access.
Consider this example: If you’re making $US5,000 a month, you can have a maximum debt obligation of $US2,150 to meet that 43% benchmark. That means that if you have no other debt, the maximum mortgage you’ll likely be approved for is that amount. However, if you have $US600 worth of payments to other loans or credit cards, you’ll only be able to get a mortgage for $US1,550, a pretty small amount.
Once you understand the debt-to-income ratio, you can see how quickly any debt affects your access to capital.
My debt-to-income ratio was so poor we couldn’t put me on our mortgage
In 2015, my husband and I were applying for a mortgage. After looking over our paperwork, the broker explained that it wasn’t even worth adding me to the financing. My income was relatively low at that point (less than $US30,000) and my high student loans meant my debt-to-income ratio was too high to help us be approved for a larger mortgage. My husband had a similar income, but no loans, so his debt-to-income ratio was much more appealing to lenders. We moved forward with just my husband on the mortgage.
That opened my eyes to the importance of debt-to-income ratio. Over the next few years I started asking myself not only “Can I afford it,” but also “How will it affect my ratio”?
That question makes me think twice about adding any debt to my plate. For example, right now I’m considering a new car, since mine needs some costly repairs. However, I’ll have my vehicle paid off next year. If I was thinking purely about affordability I might opt for a new car with less out-of-pocket expenses.
However, I’m interested in buying an investment property next year, which means I want my debt-to-income ratio in tip-top shape. I’d rather pay out-of-pocket for car repairs now, and avoid having a car payment next year. Not having the car payment will give my debt-to-income ratio a huge boost, and make it easier to get approved for financing for a rental property.
I would have made different decisions with my student loans, had I known sooner
I wish I had had this thinking from the start. One of the biggest things it would have changed is how I approach my student loans. I took out about $US70,000 in student loans to go to a private university. At the time it seemed OK: The payments were large (about $US600 a month), but I could afford them.
However, I didn’t realise how those payments would be affecting my debt-to-income ratio more than a decade later. I didn’t realise that they would be at play when my husband and I went to buy our first home.
Financial literacy is notoriously low in the United States. Like me, many people don’t learn about important financial terms like “debt-to-income ratio” until they encounter a problem. Because of that, I make an effort to explain to my friends, siblings, and even my parents what the debt-to-income ratio is, and how it affects access to financing.
- More personal finance coverage
- 4 reasons to open a high-yield savings account while interest rates are down
- It took less than 10 minutes to open a high-yield cash account with Wealthfront and earn more on my savings
- How to buy a house with no money down
- When to save money in high-yield savings
- Best rewards credit cards
- 7 reasons you may need life insurance, even if you think you don’t
Business Insider Emails & Alerts
Site highlights each day to your inbox.