Debt to income, your financial metric you’re ignoring

What is a debt to income ratio?

Why is this so important? Your debt to income ratio is all your monthly debt payments divided by your gross monthly income. This number allows lenders to measure your ability to manage your payments you make every month to repay the money you borrowed.

To calculate this, you add up all your debt payments and divide them by your gross monthly income. This is the money that you collect usually before taxes and other things that you have taken out such as, social security, in kind donations. For example, if you pay $2000 a month for your home and another $200 for an auto loan and $600 for the rest of your debts your monthly payments are $2800 ($2000+ $200+ $600 = $2800.) If your gross monthly income is $8000 then your debt-to-income ration is 35 percent. ($2800 is 35% of $8000)  

Studies from mortgage loans say that borrowers that have a higher debt to income ratio are likely to run into trouble with making monthly payments

What is the ideal DTI Ratio?

Lenders typically say the ideal front-end ratio should be no more than 28 percent, and the back-end ratio, including all expenses, should be 36 percent or lower. Depending on your credit score, savings, assets and down payment, lenders may accept higher ratios, depending on the type of loan you're applying for.

For conventional loans backed by Fannie Mae and Freddie Mac, lenders now accept a DTI ratio as high as 50 percent. That means half of your monthly income is going toward housing expenses and recurring monthly debt obligations.

Does my DTI impact my credit?

Credit bureaus don't look at your income when they score your credit, so your DTI ratio has little to do with your actual score. But borrowers with a high DTI ratio may have a high credit utilization ratio -- and that accounts for 30 percent of your credit score.

Credit utilization ratio is the outstanding balance on your credit accounts in relation to your maximum credit limit. If you have a credit card with a $3,000 limit and a balance of $1,500, your credit utilization ratio is 50 percent. You want to keep that your credit utilization ratio below 30 percent when applying for a mortgage.

Lowering your credit utilization ratio will not only help boost your credit score but lower your DTI ratio because you're paying down more debt.

How to lower your DTI.

1. Track your spending. Reduce your unnecessary purchases to put more money onto paying down your debt. Make sure you include everything, no matter small or large, you can always allocate more to paying your debt down.
2. Map out your spending. One way to pay down debt is the “snowball” method. Pay down your small credit balances first while making minimum payments on the other. Once you pay off the smaller balances you can then allocate those payments to the next smallest balance, so on and so forth. Another way is “avalanche” method. It involves going after accounts with the higher interest rates. Once you pay off the higher rate, you go to the next one. Make sure you always stick to your plan no matter what.
3. Make your debt affordable. If you have high interest rates on your credit cards you can always call to see if the creditor will lower your rate. You will have much better success if your account is in good standing, but it never hurts to try. In some cases, you can consolidate debt by balance transferring to something that has a lower interest rate. You can also take out a personal loan to lower your rate.
4. Avoid taking on more debt. That’s why budgeting and understand what you can and can’t afford is a huge leg up in understand your finances. Put everything to paper. Look at it. See it. Understanding is half the battle. Once you understand what to do, your life will hopefully be much less stress and debt filled.