by Thom Fox

 The debt-to-income ratio is an important measure of financial stability commonly used by lenders. It is a representation of your monthly debt payments vs. your gross monthly income (before taxes and other deductions). A high debt-to-income ratio can jeopardize your chances of financing major purchases, such as a car or a home. Maintaining a low debt-to-income ratio will make it easier for you to qualify for the lowest interest rates and best terms.

Calculating a Debt-to-Income Ratio
Your debt-to-income ratio is represented as a percentage. The first step in calculating this ratio is to assess your total gross monthly income. Be sure to include any additional income you regularly receive, such as:
* Alimony and child support
* Bonuses, commissions, and tips (approximate values)
* Dividends and interest earnings
* Government benefits and/or assistance

Next, list your current minimum payments on all credit cards and loans (except mortgage). Be sure to include:
* Car payments
* Installment loan payments
* Bank/credit union loans
* Student loan payments
* Credit lines

The Debt-to-Income Ratio Calculation
Monthly debt payments ÷ gross monthly income
Example:
* Monthly debt payments = $700.00
* Gross monthly income = $3,200.00
* Debt-to-income ratio = 700 ÷ 3,200 = .218
* Note: To get a percentage, multiply 0.218 x 100. This would be 21.8% (round up to 22%).

Why Use Your Gross Income?
When qualifying for a high-ticket item such as a home, this method allows you to make a more expensive purchase. Though you can qualify for a larger mortgage amount, you must always remain conscious of what you can actually afford. Let’s look at an example of a consumer who does not take affordability into consideration.

* Johnny First-Time Home Buyer has an annual gross income of $70,000.
* His gross monthly income is $5,800.00.
* He qualifies for a $188,500 mortgage.
* His monthly mortgage payment would be $1,254.00.

At first glance, it doesn’t look like Johnny will have any problem making his monthly payment, but remember, this was based on his gross income. Let’s take a look at what his net income (take-home pay) would be.

* He has an annual gross income of $70,000.
* He’s in the 30% tax bracket.
* He pays $21,000 a year in federal tax.
* He pays $2,800.00 a year in state tax.
* He pays $4,340.00 a year to Social Security.
* He pays $720.00 a year in medical insurance.
* His net income would be: 70,000–21,000–2,800–4,340–720 = 41,140
* Johnny brings home $41,140 each year, or $3,428.00 a month.
* His monthly mortgage payment would be 36.5% of his net income.
 
In this example, Johnny may experience difficulties making his mortgage payment depending on what his overall budget looks like. As I emphasized in my earlier budgeting column (First-Time Home Buyer, Spring 2006), many people will tell you that you’d be crazy not to take out the maximum loan that they say you can afford according to their calculations. The truth is, they don’t know what you can afford. Remember, they’re using your gross income. Only you know where your money goes. Therefore, only you can determine just how much you can afford as a monthly mortgage payment.

What Is an Acceptable Debt-to-Income Ratio?
Generally, the lower a debt-to-income ratio is, the better the consumer’s financial condition. The credit opportunities described below are typically extended to consumers who fall into the ranges shown. 

• A ratio of 10% or less: Should not have trouble getting loans. May qualify for lower rates.
• 11–20%: Should not have trouble getting loans. Time to scale back on spending.
• 21–35%: May not have trouble getting new credit cards, but is spending too much of monthly income on debt repayment.
• 36–50%: Will qualify for certain loans, but at higher rates. Time to develop a plan to get out of debt.
• More than 50%: Will have great difficulty qualifying for financing.

 
Thom Fox is a public speaker and personal finance author who has helped to develop numerous programs for both young people and adults. As an expert in the field of personal finance, Mr. Fox has served as a guest lecturer for the Bruce Wells Scholarship Upward Bound program at Clark University and panelist for both the Nichols College “Cycle of Debt in America” student Q & A and the California JumpStart Coalition “Innovative Financial Literacy for Youth” conference.