Your debt-to-income ratio is an important metric when it comes to determining whether you qualify for certain types of loans. It's typically associated with mortgage loans, but lenders may use it to determine eligibility for auto loans, personal loans or other types of credit.
It's one of those key financial metrics that lenders use to evaluate you as a credit risk, so understanding what it is, how it relates to creditworthiness and how to improve it is essential.
[Read: 10 Easy Ways to Pay Off Debt.]
If you're considering taking on a loan, you might have these questions about debt-to-income ratio:
-- How is debt-to-income ratio calculated?
-- What is a good debt-to-income ratio?
-- How does debt-to-income ratio relate to my credit score?
-- How can I improve my debt-to-income ratio?
-- Why is debt-to-income ratio important?
Read on for the answers to each of these questions.
How Is Debt-to-Income Ratio Calculated?
To calculate this financial figure, lenders divide your monthly debt payments into your gross income (what you earn before taxes and other deductions). For example, if you owe $1,000 per month in mortgage payments, $500 per month in auto loan payments and $500 per month in credit card payments and other debts, then your total debt is $2,000. If you earn $5,000 in gross income per month, your debt-to-income ratio would be $2,000/$5,000, or 40 percent.
Lenders often accumulate the data used to calculate the ratio when you submit a loan application, which may require everything from pay stubs to tax returns and bank statements, depending on the type of loan for which you are applying. Additional debt information can come from your credit report.
What Is a Good Debt-to-Income Ratio?
Typically, a lower debt-to-income ratio is preferable because it demonstrates that you have sufficient income to repay outstanding loans. One important figure for mortgage debt is 43 percent. In most cases, 43 percent is the highest ratio a borrower can have and still get what's called a qualified mortgage, according to the Consumer Financial Protection Bureau. A qualified mortgage is a safer, more transparent loan for borrowers who are eligible.
An important caveat to keep in mind: Debt-to-income ratios don't tell the whole story about a person's financial health, says Gerri Detweiler, education director for Nav, a San Mateo, California-based service that matches small-business owners to financing options. "Debt-to-income ratios can mask some pretty extensive debt," she says. For example, when determining credit card debt, lenders will include the minimum required monthly payment in your debt-to-income ratio, not the larger amount required to pay off your bill each month.
How Does Debt-to-Income Ratio Relate to My Credit Score?
A history of making good credit decisions and only taking on loans you can repay is smart for your debt-to-income ratio and your credit score. But beyond that, the relationship between debt-to-income and credit strength isn't always clear-cut.
"The more important thing that consumers need to be aware of is debt-to-available-credit," says Bill Hardekopf, CEO of LowCards.com. That metric, sometimes called the credit utilization ratio, is a measure of how much debt you take on versus how much is available to you. It factors into the calculation of most commercial credit scores, unlike debt-to-income, and experts recommend keeping it below 30 percent.
How Can I Improve My Debt-to-Income Ratio?
Paying down debt or selling financed assets, such as pricey cars, will improve your debt-to-income ratio. But that strategy may have an unintended impact on your credit score, Detweiler warns.
For example, say you decide to aggressively repay your car loan to improve your debt-to-income ratio. "Paying off a car loan may cause your credit to drop a little bit (because) now you don't have an open-installment loan," Detweiler says. "I would definitely talk to your mortgage professional before you make any drastic moves related to your credit."
Why Is Debt-to-Income Ratio Important?
While your debt-to-income ratio shouldn't be the deciding factor in what home -- and in what price range -- you choose, it can have an important impact on the kinds of loans you can get. And the types of loans for which you qualify, especially mortgage loans, can have a measurable effect on your lifestyle. "Good debt-to-income could mean the difference between a good school district and not-so-good," Detweiler says. "It can matter a great deal to not just what you can afford, but your quality of life."
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