Debt-to-income ratio compares income generated in a specific period with debt that must be paid during the same period. It helps determine the amount of additional debt that can be taken on without creating financial hardship. Lenders set a percentage range for the ratio, with a ratio greater than 50% resulting in loan rejection.
The debt to income ratio is a simple comparison of the income generated in a specific period with the amount of debt that must be paid during the same period. Typically, a debt to income ratio is calculated for a period of one month, providing a snapshot of what must be earned to pay monthly obligations. Debt-to-income ratios are useful in determining the amount of additional debt that can be taken on without creating financial hardship.
Understanding the relationship between debt and income is helpful in several different ways. For people trying to develop a workable monthly budget, it is important to identify all current obligations and what type of monthly payment is required to keep debts current with creditors. For lenders, getting a true picture of the debt-to-income ratio helps assess a borrower’s ability to take on additional debt.
There are actually two distinct forms of debt to income ratio. The first is known as front end or high debt ratio. This ratio involves comparing gross monthly income to monthly housing expenses. While not a complete picture of monthly debt obligations, this approach demonstrates whether the borrower can continue to pay for the home if an additional loan obligation is added to the mix.
Back-end or low debt-to-income ratios focus on adding all fixed monthly expenses to get total monthly obligations and comparing the total to the amount of gross monthly income. Along with basic housing obligations, monthly debts such as child support, health insurance payments, credit card payments, and alimony payments are also taken into account. This approach to determining the true financial status of the borrower provides a clearer idea of the total current debt load and gives the lender a better idea of how much risk is involved in extending the loan.
It is important to note that the calculation of a debt to income ratio will always include obligations that appear on a credit report. This means that existing loans and other fixed monthly expenses will be present. However, variable expenses are not likely to show up on a credit report and therefore must be disclosed by the borrower.
Lenders also tend to set a percentage range for the debt to income ratio. When the debt to income ratio calculator indicates that the down payment ratio is no more than 35% of gross income and the fund ratio is no more than half of gross income, the borrower is generally considered a good risk. However, if the debt to income ratio is greater than 50%, lenders may reject the loan application.
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