Your debt-to-income ratio is one of the measures used in financial planning to establish how much of your income is used to repay debts. It is commonly used when you are applying for a mortgage loan to purchase a property. The lender will use this figure to help them decide whether or not you will be able to afford to make mortgage loan repayments. Most people do not calculate and make use of this ratio provides in any other situation, but maybe you should consider whether it can help you with your own financial planning, particularly in the current economic climate.
How to calculate your Debt-to-Income ratio.
Unlike most financial planning methodologies, calculating your debt-to-income ratio is quite straight-forward. However, there are two versions of the ratio, one which concentrates solely on your housing related debt and one which is more all encompassing taking account of your full debt load. It is worth emphasizing here that your normal daily living expenses, such as groceries, electricity and phone costs, are not part of your debt load and are not included in either of these calculations.
Both versions of the ratio are calculated in the same way, it is simply the extent of any debt that you have which makes the difference between them.
Version 1 – Housing debt-to-income ratio
To calculate this ratio, which usually expressed as a percentage, simply sum your gross monthly income and separately total all your monthly housing related debts, so this will include items such as mortgage repayments, buildings insurance and contents insurance. The next step is to calculate your debt burden as a percentage of your total income.
Gross Salary = $4,000 per month – no other income.
Total Monthly Income is $4,000.
Mortgage payments = $900 per month
Buildings insurance = $50 per month
Contents insurance = $50 per month
Total Monthly Housing Debt is $1,000 per month.
Debt-to-Income ratio = Total Monthly Housing Debt / Total Monthly Income x 100
Debt-to-Income ratio = 1,000 / 4,000 x 100 = 25%
Version 2 – Total debt-to-income ratio
This is calculated in exactly the same way as the Housing debt-to-income ratio, except that all debts are included. So when calculating the total monthly debt, you will include all loans and outstanding monies owed. For example, this might include personal loan repayments, car loan repayments and credit card repayments.
How to interpret your debt-to-income ratio
Individuals will have their own view on what constitutes an acceptable debt-to-income ratio. It will depend on their circumstances and their emotional reaction to holding debt. Mortgage lenders have a reasonably consistent view. They would generally consider around 36% as acceptable, though will allow a small margin above this. Once the ratio reaches the 41%-50% range, most lenders would anticipate financial difficulty will soon be felt and would probably consider someone with this level of debt burden a poor lending risk. Once your debt-to-income ratio exceeds half of your income, you are likely to be in financial difficulty already, and if not, it could be just around the corner.