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Calculating Your Debt to Income Ratio: What’s the Sweet Spot for Lenders?

Calculating Your Debt to Income Ratio: What's the Sweet Spot

Calculating Your Debt to Income Ratio: What’s the Sweet Spot for Lenders?

The Housing Affordability Index is something that experts use to determine if a family earns enough money to buy a house. You must make enough money to qualify for a loan, so this index is vital.

When you apply for a loan, you probably will not hear anything about this index, though. Instead, your lender might talk about numbers, amounts, and ratios, and they will likely bring up the debt to income ratio.

If you aren’t sure what the debt to income ratio is, you should learn before applying for a loan. This ratio helps lenders determine your risk level and loan amount, and all lenders use it.

Here is a guide to help you learn the definition of this ratio, what a good one is, and other information relating to debt to income ratios in lending.

The Definition of Debt to Income Ratio

Lenders use various tools and calculations when evaluating loan applications, and one of these is debt to income ratios. A debt to income ratio compares a person’s debt payments to their income to see where they stand.

The purpose of this calculation is to determine risk. People with high debt to income ratios might have trouble repaying loans, as they already have high debt loads. As a result, a bank will consider a person like this a high risk.

People with lower ratios might face fewer challenges in paying their loans. Banks view these individuals as low-risk borrowers.

Your debt to income ratio reveals a lot about your financial picture. Not only is this important to understand, but it is also essential to calculate your ratio before applying for a mortgage.

How to Calculate Your Debt to Income Ratio

Are you wondering how to calculate debt to income ratio? If so, here is an explanation to help you learn how to determine yours. To find your debt to income ratio, you must know two main things:

  1. Your gross monthly income
  2. Your total monthly debt payments

First, your gross monthly income is a total of all the income you earn per month. It is the amount you earn before taxes, and it should include income from all sources.

Next, your total monthly debt payments include routine debts you must pay each month. Your total debt payments might include your car payments, student loans, credit cards, and other loan payments.

You do not include your regular monthly expenses, such as utility payments and insurance. This ratio only factors in other types of expenses that are “extras.” In other words, you should add in any types of loans that you will eventually pay off.

Once you have these two amounts, you divide your gross monthly income by your total monthly expenses. The answer you get is a percentage, and this percentage is what matters to lenders.

If you have trouble calculating these amounts yourself, you could use a ratio simplifier, which is a tool that calculates the ratio for you. To use it, you input the amounts it asks for, and the tool provides your debt to income ratio.

What Lenders Look for With These Ratios

While lenders view factors other than your debt to income ratio, this ratio is one of the most important factors in a lender’s decision. What is a good debt to income ratio, you might wonder?

Most lenders view a ratio of 43% or less; however,  most lenders prefer a ratio of 36% or less. If your ratio is higher than 43%, you will probably face challenges getting approved for a loan.

This ratio reveals a lot about your risk level. When a person has few debts to pay each month, they may have an easier time paying their bills. People strapped with major debt loads, on the other hand, often face more challenges paying their bills.

Banks know this and fully understand how this works, which is why they place a lot of weight on a person’s debt to income ratio. If you’re worried that yours is too high, you might want to work on improving it before applying for a loan. 

Ways to Improve Yours Before Applying

So, what is the best way to improve your debt to income ratio? Well, there are several options you can pursue.

The main goal is to increase your income and decrease your debt payments. If you can achieve these goals, you can transform your ratio to meet the sweet spot that lenders look for when evaluating loan applications.

The first step is to find ways to increase your income. Is there a way you can work overtime at your current job to bring home more money? Could you take on a second job or start a home business to increase your income quickly.

Finding ways to increase your income will instantly help you improve your debt to income ratio. The next step, though, is finding ways to reduce your expenses.

The most logical way to decrease expenses is by paying off your loans. For example, if you have a car loan with a $500 monthly payment, is there any way you could pay off the balance of the loan? If so, you’ll see a positive change in your ratio.

Keep in mind; you shouldn’t use all your cash to pay off your loans, though. You must keep some for your down payment and moving expenses. If necessary, you might want to spend a few months working on paying off your debt before applying.

If you can pay off enough debt in a few months without using all your savings, you’ll see an improved financial position.

Make Sure You Prepare Financially Before Applying

As you can see, your debt to income ratio matters a lot when applying for a mortgage. Additionally, your credit score also matters, as does your financial picture.

If you feel like you’ve learned a lot about mortgage lending in this article, you might be ready to learn more. You can learn more by browsing through our website for lots of other articles.