You probably know, or can figure out, what a debt-to-income ratio is and that lenders use it to decide if they want to offer you a loan or mortgage.
What you may not know is that the way lenders evaluate loan-worthiness should not be how you calculate how much debt you can take on. In fact, the ratio matters for more than just lending. It’s vital to understanding your overall financial health.
For those just learning about this important financial metric, here are the calculations:
Calculating Debt-to-Income Ratio
What is a debt-to-income ratio? It’s just what it sounds like: a comparison of the amount you owe to what you take in each month. If your ratio is too high (too much debt), you’re headed for financial trouble. To calculate your ratio, simply add up all of your monthly debts, including mortgage, homeowner’s insurance coverage, housing taxes, rental payments, credit cards, personal loans, car payments (not including car insurance), and child support. Divide the total by your gross income, or the amount you make every month before any deductions. The resulting number is your ratio.
Numbers the Lenders Use
During the height of the real estate investing boom, lenders were accepting ridiculously high ratios, such as the 41% allowed by FHA programs for high-risk loans. While you might survive on this ratio, you’ll be eating macaroni and cheese for dinner most nights. These days, the magic number is around 36%. But even then, you need an excellent credit score to qualify.
Why “Good” Debt-to-Income Ratios Don’t Always Work
Ideally, you should be able to put away 20% of your gross income, with 10% applied to retirement and 10% applied to long-term savings or an emergency fund. The remaining 80% is left for your taxes, loans, bills and entertainment.
If 36% of your income is going to debt (as the lenders have calculated) and 20% to savings, that leaves you only 44% of your income for entertainment and utility bills. Even a $1,000 weekly gross salary would leave you with only $440 per week, which after taxes would leave you around $300. That’s all you would have for your utilities, groceries, and all the other necessities of living. For many, that is not enough, especially if you’re forking out $200 per week in daycare expenses.
Most financial experts will tell you that 36% is a healthy debt-to-income ratio, but they don’t take into account the fact that most families have two income earners and therefore have to pay for childcare (as opposed to families living on one income with a stay at home mom or parent). That’s why you cannot depend on the ratio used by lenders to diagnose your own financial health, and also why the ratio matters for your daily budget.
Personalizing your Debt-to-Income Ratio
Instead of following lenders’ protocol, personalize the ratio to better address your financial situation. For starters, deduct your health care costs right off the top. You can add back in 20% to 35% of the cost up to $6,000. Look at your credit from last year’s taxes to find out what percentage you should be using. If you pay more than $6,000 per year and were given a 35% credit, then you should add $2,100 back into your gross before making your calculation.
Based on a $50,000 salary, and assuming approximately $10,000 in childcare costs (yours may be more or less), you would calculate your ratio on an income of $42,100. No matter what the lender says you can afford, you’ll know that you should not spend more than $15,156, or $1,263 per month, on debts.
Based on standard industry calculations, the lender says you can afford $1,500 per month, but that would in fact put you into debt by hundreds of dollars every month. You’d have to make between $57,000 and $58,000 per year to afford the loan a lender would offer. In this case, a healthy debt-to-income ratio is more like 30%. If you pay childcare expenses for even one child, you’re much safer calculating your ratio between 25% and 30% when creating your personal budget.
Jessica Bosari writes for the money-saving site, Billeater.com. The site is devoted to helping people reduce expenses, save money and find great deals. Pay Billeater a visit for more money-saving tips!