Just like physical health, financial health turns on a slew of different factors, some more important than others. It’s tough for nonexperts to keep track of them all.
While you don’t need encyclopedic knowledge of all the components of a good credit score or the considerations involved in loan underwriting decisions, it doesn’t hurt to know what pleases lenders – and what turns them off.
Besides your credit score itself, the one metric worthy of further investigation is your debt-to-income ratio.
It’s hard to overstate debt-to-income’s centrality to the underwriting process. If your ratio is too high, you’ll find it very difficult to secure personal loans and other types of credit at reasonable rates. That can have serious ramifications for your lifestyle and personal financial health, some of which we’ll discuss in greater detail below.
Here’s what you need to know about the debt-to-income ratio: how it’s calculated, why it matters, its limitations as an indicator of financial health, and what you can do to improve your personal or household ratio.
What Is the Debt-to-Income Ratio?
It’s a pretty simple concept.
Your debt-to-income ratio compares what you owe against what you earn. In mathematical terms, it’s the quotient of your monthly obligations divided by your monthly gross income: R = D/I, where D is your total debt, I is your total income, and R is your debt-to-income ratio.
How to Calculate Your Debt-to-Income Ratio
You can calculate your debt-to-income ratio in four easy steps:
- Add Up Your Debts. First, add up all your debts. Obligations commonly used to calculate your debt-to-income ratio include mortgage (including escrowed taxes and insurance) or rent payments, car payments, student loan payments, personal (and other) loan payments, loan payments on any loans you’ve co-signed (an important line item for parents with debt-burdened adult children), alimony, child support, home equity loan payments, and minimum credit card payments (even if you charge more). This is not a complete list of debts that can factor into your debt-to-income ratio. If you’re unsure about what your lender looks for, ask your loan officer directly.
- Exclude Expenses Not Considered Debts. Your debt-to-income ratio’s numerator only includes expenses deemed debts. It’s not a total accounting of your monthly liabilities. Non-factored expenses commonly include utility payments (such as water and electricity), most types of insurance (including auto and health insurance), transportation expenses (except car loans), cell phone bills and other telecommunications expenses, groceries and food, most taxes (excluding escrowed property taxes), and discretionary expenses (such as entertainment).
- Add Up Your Gross Income. Add up all sources of income, before taxes. If you have a full-time W-2 job, this is as easy as looking at your most recent paycheck. If you have multiple part-time jobs, work as an independent contractor for multiple clients, or own a small business, it’s probably easiest to refer to the prior year’s tax return (assuming your income has not changed significantly) or manually add up receipts using your most recent bank account statements.
- Divide Step 1 by Step 3. Divide your total monthly debts as defined in Step 1 by your gross income as defined in Step 3. That’s your current debt-to-income ratio!
Here’s a simple example. Say your total aggregate monthly debt, excluding non-debt expenses, is $1,500. Your monthly gross income, before taxes and household expenses, is $4,500. Your debt-to-income ratio is $1,500/$4,500, or 33.3%.
Why Your Debt-to-Income Ratio Matters
Debt-to-income is among the most important factors lenders use to evaluate loan applicants.
For lenders, your debt-to-income ratio is a reliable indicator of your ability to repay a new loan in a timely fashion. Statistically, the higher your existing debt load relative to your current income, the likelier you are to fall behind on debt service.
Mortgage lenders are particularly cognizant of applicants’ debt-to-income ratios. Mortgage underwriters, and the servicing companies that purchase most mortgages after they’re issued, have little incentive to issue risky loans to applicants who might struggle to meet their existing obligations.
Lenders that do issue higher-risk mortgage loans – known as subprime mortgages – compensate for the added risk by demanding larger down payments and assigning higher interest rates. Subprime mortgage loans often require down payments well north of 20% and charge interest in excess of 8% APR, compared to 3% to 5% for prime mortgages.
What Is a Good Debt-to-Income Ratio for Lenders?
Every lender is different, but 36% is the generally accepted debt-to-income cutoff for prime mortgage loans. That’s the maximum debt-to-income ratio permitted under Fannie Mae’s rules for manually underwritten loans.
Fannie Mae does make exceptions to the 36% rule. According to Fannie Mae’s Eligibility Matrix, Fannie Mae permits debt-to-income ratios as high as 45% on loans made to borrowers with higher credit scores and cash reserves.
Loans made to borrowers whose debt-to-income ratios exceed 43% may lack important borrower protections, such as limits on up-front “points” charges and interest-only periods. Check the Consumer Financial Protection Bureau’s literature on Qualified Mortgages for more details about what is and isn’t permitted.
Smaller creditors are exempt from rules governing Qualified Mortgages and may therefore issue favorable mortgage loans to borrowers with debt-to-income ratios in excess of 43%. Small creditors are defined as lenders with under $2 billion in assets and 500 or fewer mortgages issued in the previous year. Bear in mind that lenders have final discretion over underwriting decisions – and that, no matter how lenient your lender, you’re likely to face higher interest rates and down payment requirements if your debt-to-income ratio exceeds 36%.
Is the Debt-to-Income Ratio a Good Indicator of Financial Health?
It’s probably clear by now that the debt-to-income ratio is not a proxy for household cash flow. By excluding broad expense categories, such as utilities, insurance, and food, debt-to-income is at best an incomplete picture of your overall financial health. Though it’s easier to spend more than you earn with a wallet full of credit cards or a vast portfolio of personal loans, excessive leverage isn’t the only factor that can compromise your financial resilience.
Debt-to-income is a good indicator of your personal creditworthiness, if only due to the degree to which lenders rely on it in underwriting decisions. But your “out of the box” debt-to-income ratio, defined in the four steps above, isn’t enough to produce a holistic picture of your financial well-being.
To achieve that, you need to redefine “debt.”
How to Calculate a Personalized Debt-to-Income Ratio
Your personalized debt-to-income ratio should account for recurring, unavoidable personal or family expenses not included in the Step 2 definition of “debts.” Such expenses might include:
- Health insurance
- Auto insurance
- Home insurance, if not bundled in escrow
- Childcare costs, if you have young kids in a single-parent or two-earner household
- Income taxes, if not wholly withheld from your paycheck
- Utility and communications expenses
Obviously, the more expenses you include, the closer you’ll come to simply rehashing your household’s budget. (If you don’t already have a household budget, read up on how to make a personal budget for the first time.)
You can avoid that by concentrating on the largest obligations: in most cases, health insurance and childcare. Before calculating your personalized debt-to-income ratio, subtract your health insurance costs and childcare costs (if applicable) from your gross income.
If you qualify for tax credits or deductions related to either expense, add those back in. Depending on your income, you may qualify for a tax credit equal to 20% to 35% of qualifying daycare or other supervisory expenses for children and dependents under age 13, capped at $3,000 in expenses for one child and $6,000 in expenses for two or more children. The full credit is only available to lower-income parents. If you earn more than $43,000 per year, your credit is capped at 20%. (This threshold is subject to change each tax year, so refer to your most recent tax return and current IRS publications before making any assumptions about your eligibility.)
Calculating Your Debt-to-Income Ratio: An Example
Let’s walk through an example. Say your share of your health insurance plan costs you $2,500 per year, your childcare expenses total $11,000 per year for two children, and your gross annual income is $70,000. Assuming your children qualify for the child and dependent care tax credit, you’d be able to claim $2,200.
To find your “true” income basis for a personalized debt-to-income calculation, you’d subtract $13,500 from $70,000, then add back $2,200: $58,700 annual income, or approximately $4,892 per month.
You can then use your income basis to determine your maximum recommended debt load, based on lenders’ debt-to-income thresholds. If you’re applying for a mortgage and want to be sure you qualify for the best possible rates and terms for your credit profile, shoot for no more than 36% debt-to-income. At a monthly income basis of $4,892, without accounting for any additional expenses, you can afford to spend no more than $1,761 per month on debt service.
Tips to Improve Your Debt-to-Income Ratio
Reducing your debt-to-income ratio may seem self-explanatory, but paying down debt is often easier said than done. Follow these tips to make a meaningful, timely impact on your debt-to-income ratio before you apply for a mortgage or another major loan:
- Excise One Discretionary Expense From Your Budget Each Month. It could be a morning latte, a cable-phone-Internet package you barely use, a meal delivery subscription you don’t have time to cook. Identify one such financial weakness per month, make a plan to live without it, and excise it from your budget.
- Accelerate Installment Debt Payments. Installment loans include car loans, mortgages, personal loans, and other loans with fixed monthly payments. (By contrast, credit cards and home equity lines of credit care are known as “revolving” debts, since you can draw on them freely and the outstanding balance can rise or fall accordingly.) If high monthly payments on installment loans factor into your elevated debt-to-income ratio, try adding a bit to each payment to reduce the number of months necessary to pay off the balance. For borrowers primarily concerned about reducing debt-to-income in the short- to medium-term, this strategy works best with loans approaching payoff: say, a car loan with 24 monthly payments remaining. It’s not as effective for recently issued longer-term loans: say, a 30-year mortgage with 280 months left to go. Paying more toward longer-term loans’ principals each month can reduce the loan’s total interest cost. That’s good for your long-term financial health, but not directly pertinent to your near-term debt-to-income situation.
- Pay Off Credit Cards in Full Each Month. Unless you’re taking advantage of a limited-time 0% APR promotion to finance a large purchase or pay down a higher-interest credit card debt via balance transfer, don’t carry month-to-month credit card balances. Doing so raises your minimum monthly payment – and with it your debt-to-income ratio.
- Take Advantage of Balance Transfer Offers. If your credit is in good shape, you may qualify for low APR credit cards, such as Chase Slate or Citi Simplicity. These cards often come with long 0% APR balance transfer offers that essentially freeze interest accumulation on transferred high-interest credit card debts, reducing the cost to pay them down. Take advantage of them!
- Pick Up a Few Hours of Freelance Work Each Week. Increasing one’s income is often easier than decreasing one’s debt. If you have marketable skills or talents that translate well to the freelance contracting or consulting marketplace, hang out a digital shingle. Look for jobs on reputable freelance work websites.
- Postpone Large Purchases. Planning a major home improvement project? Pining for a new car? Consider putting off those purchases until your existing debts are under control. If you need to finance any portion of these purchases, you’ll increase your debt-to-income ratio, undoing some or all of the hard work you’ve put in.
- Avoid Applying for New Loans or Credit Cards. Those “preapproved” credit card offers are tempting, but they’re not good for your debt-to-income ratio. Avoid taking on new debts, especially high-interest loans and lines of credit, until your debt-to-income ratio is under control. Avoid predatory loans, such as payday loans, altogether.
The debt-to-income ratio is easy to understand in the abstract. Where the rubber hits the road, things aren’t always so clear-cut.
If you take one conclusion away from this post, I hope it’s that your debt-to-income ratio is not the be-all-end-all arbiter of your financial health. Yes, it’s a critical underwriting consideration for lenders, and a high debt-to-income ratio is likely to raise your borrowing costs or exclude you from contention altogether. But it’s simply not possible to gain a full, measured picture of your financial status from this one number alone.
Have you calculated your debt-to-income ratio lately? Is it in good shape, or is there more work to be done?