How to Calculate Debt to Income Ratio

A lot has been said about the importance of credit scores for availing a mortgage. As a rule, one can safely assume that a high credit score is a necessary condition for availing a mortgage at a favorable rate of interest. However, having good credit scores alone will not suffice. This is because high credit scores imply that the consumer has established a history of timely payments. Whether the consumer can afford to avail a home mortgage, and continue to discharge financial obligations without any hitch, is best indicated by the debt-to-income ratio. Hence, the query, 'how to calculate debt to income ratio' assumes a great deal of significance. It is important to note that the credit bureaus do not take the debt-to-income ratio into account for computing credit scores.

For a mortgage lender, the debt-to-income ratio is as important as the consumer's credit scores. Unlike the computation of credit scores, the calculation of the debt-to-income ratio is a fairly easy task. Consumers can easily calculate the debt-to-income ratio, provided they are aware of their gross income, their total housing expense and the sum total of their debt obligations. The housing expense ratio and the total debt-to-income ratio are the standard ratios that are used by lenders for determining the capacity of the consumer to afford a mortgage.

Housing Expense Ratio
This ratio is calculated by dividing the total housing expense (monthly or annual) by the gross salary (monthly or annual respectively) of the consumer. Housing expense includes mortgage principal, interest payments, property taxes, hazard insurance, mortgage insurance and association fees.

Housing Expense Ratio = Housing Expense/Gross Salary

Total Debt-to-Income Ratio
Total Debt-to-Income Ratio is calculated by dividing the total debt obligation (monthly or annual) by the gross income (monthly or annual respectively). Total debt obligation includes payment for car loans, child support, alimony, credit card bills, student loans, rent, mortgage payments etc.

Total Debt-to-Income Ratio = Total Debt Expenses/Gross Salary

Interpreting Debt-to-Income Ratio

Ideally, people should not be spending more than 28 percent of their gross salary on mortgage payments. A housing expense ratio that is greater than 33 percent is definitely not advisable. If the total debt-to-income ratio exceeds 36 percent, it is a warning signal and indicates that the consumer may not be able to keep up the mortgage payments.

One can safely say that a person with poor credit scores and a high debt-to-income ratio will be denied a mortgage. Debt to income ratio for a consumer may be high despite him/her having good credit scores. This situation indicates that the consumer is paying-off debt obligations regularly. However, in case of unforeseen expenditure the consumer may find it difficult to meet financial obligations since a huge chunk of the salary is going towards repaying debt obligations, leaving very little scope for saving and investment. One must remember that a horde of deductions are necessary before one can arrive at the net income.

Improving the Debt-to-Income Ratio

The total debt-to-income ratio should be as low as possible so that lenders do not feel uncomfortable about extending credit to the consumer. People who are interested in improving their debt-to-income ratio can do so by lowing their debt expense or by increasing their income. As far as reducing debt expense is concerned, one can try debt consolidation. Debt consolidation results in the consumer availing a loan that carries a rate of interest that is lower than the rate on existing loans and paying-off the remaining loans with the new loan. This ensures that the monthly (annual) debt expense is less than the current debt expense. One must remember that debt consolidation generally results in one being stranded with the new loan for a long period of time. Thus, one may end-up paying more over the years.

Hopefully, the above article would have answered the query concerning how one must calculate debt to income ratio to the satisfaction of the reader.