Borrowing money entails responsibility. You must be able to consistently make repayments on time. For that reason, lenders have to look at several aspects of your finances before extending you a loan. Income, credit score, and debt-to-income ratio are among the factors they will closely examine to ensure that you can meet your financial obligation.
Whether you’re purchasing a house, buying a car, or consolidating debts, understanding what some lenders like CreditNinja are looking for can help you make good sense of your financial health. Note that when it comes to borrowing money or taking out a loan, how much you owe relative to the amount you make is of utmost importance.
That’s where the debt-to-income ratio (DTI) comes into play. To better grasp its role in your finances, let’s learn what it is and why calculating debt and income matters.
Understanding Debt-To-Income Ratio
The debt-to-income ratio determines how much of your monthly income goes into paying your debts. Lenders utilize it to assess how financially comfortable you would be taking on new debt. By looking at all your monthly debt payments against your gross monthly income, they are able to see if you have enough cash to take on another monthly payment.
How To Calculate Your DTI?
It‘s pretty simple to compute your debt-to-income ratio. You will just add all your monthly debt obligations and divide it by your gross monthly income or the amount of income you earn before discounting the taxes and deductions. Then multiply the number by 100 to see the percentage.
Let’s say you pay $650 a month in rent, $150 for your car loan, and $250 a month in student loans, and then you have a monthly gross income of $3,500. In this case, your debt-to-income ratio will be 30% ($1050 ÷ $3,500 x 100). It shows potential lenders that 30% of your gross monthly income goes towards paying debts while the remaining 70% for other monthly costs.
What’s The Ideal DTI?
The ideal DTI depends on what type of loan you are applying for. Some lenders may require a lower DTI, while others may allow a higher one. But generally, lenders prefer if it’s not higher than 36%. It means that if your monthly gross income is $8000, your total debt obligations must be $2,880 or less. However, if your goal is to be debt-free, you should aim for a DTI of 0%.
Why Calculating Your DTI Is Essential?
Evidently, your debt-to-income ratio is as important as your credit score. But though it is one of the measurements a lender uses to evaluate your creditworthiness, calculating your DTI matters regardless if you’re planning to take out a loan or not.
Here are the reasons why:
Determine Borrowing Capacity
If you’re planning to take out a loan, you most likely want to know how much you can borrow. By calculating your debt-to-income ratio, lenders will see how much of your income is allocated for debt payments every month. From there, they can set an appropriate amount based on how much you will have leftover for other expenditures.
Even if you’re not borrowing money anytime soon, it will help to calculate your DTI, so you have an idea of your borrowing capacity in case you need to cover some emergency expenses. Although DTI is just one of determining factors, it’s a good place to start.
Keep Track Of Your Debt Loads
Once you know your debt-to-income ratio, you have a better picture of your debt loads. Since loans have become more accessible than ever, it’s easy to take on debts without considering your capacity to make repayments. By calculating your DTI, you can keep track of how many debts you’re carrying and whether or not getting another loan is sensible for your situation.
For instance, your debt-to-income ratio is more than 50%. It gives you an idea that you already have too much debt since you’re spending at least half of your monthly income on debt payments. With that, you can make more informed financial decisions, especially when it comes to debts.
Improve Financial Habits
Your debt-to-income ratio can serve as a financial check-up. A high or low DTI can be your guide to improve financial habits. If your debt percentage falls in a healthy range, which is 36% or less, you can make better ways to maintain such a good ratio. The result also tells you if there are necessary adjustments you have to make in your monthly budget.
Once you find out that you have a high debt-to-income ratio, you can assess what factors significantly contribute to such results. If your DTI is between 43% to 49%, it can be an indicator that you’re in financial trouble, and you must start paying your debts aggressively.
A ratio of 50% or more can mean that your financial health is already at risk, and you must not incur more debts unless you’re able to pay down the outstanding ones. Never hesitate to ask for professional help if you think your debt loads are already too hard for you to manage.
Manage Your Debts Carefully
Debts are not entirely bad as long as they are on a manageable level. Hence, it’s essential to understand your debt-to-income ratio to make certain that you’re not taking on debt more than what you’re earning. It also helps you stay on top of your finances by building healthy financial habits and making more sensible financial decisions.