Yara Zakharia, Esq.

In the United States, a two-digit number known as the debt to income ratio provides valuable information to both creditors and debtors.  Deemed by many experts to be as pivotal as the credit score, this personal finance indicator offers insight into a consumer’s financial health and ability to repay future loans or debt.  Constituting one of the leading criteria for loan approval, the debt-to-income rate consists of a comparison of a borrower’s pre-tax monthly earnings or gross income to his or her monthly secured and unsecured debt obligations (i.e. credit card debt, student loans, auto loans, mortgages) and payments to lenders.  This consumer debt measure evaluates whether consumers have sufficient income to pay their bills in a timely manner.

Consumers trying to figure out how to get out of debt should abide by a simple rule, namely, to maintain their debt within 20% or less of their total income.  To determine whether or not a prospective borrower is creditworthy and can afford to take out a loan and to ascertain the amount for which he or she qualifies, lenders rely on the debt to income ratio.  This tool enables banks and other creditors to evaluate a consumer’s eligibility for a student loan, car loan, or mortgage.  By familiarizing themselves with the debt-to-income rate and debt relief methods, borrowers can increase the likelihood of obtaining lower credit card rates, a mortgage on better terms, or a more attractive auto loan.

A low debt to income ratio signifies a healthy balance between income and debt.  As a general rule, borrowers should opt for a debt-to-income rate that is below 36% since this will enhance their chance of obtaining credit.  In other words, consumers’ debts such as student loan payments, credit card bills, auto loan payments, and mortgage payments should stay within 36% of their income.  The ‘under 36%’ threshold is applied by credit card companies and lenders when deciding the amount of funds to lend applicants.  Borrowers with a debt to income ratio that is higher than 36% are often subject to higher rates of interest since they pose a higher risk to lenders.  Creditors usually set a ceiling on the debt-to-income rate and refuse to lend money to applicants with ratios that do not fall within its guidelines.  Prospective borrowers with too high a rate face greater obstacles in obtaining financing.  Consumers with a debt to income ratio between 37% and 42% generally find it easy to qualify for a credit card but harder to qualify for a loan.  Those with a 43% to 49% rate should consider implementing debt management techniques in order to avert impending financial difficulties.   Borrowers with a ratio of 50% or more are well-advised to consult a credit counseling agency or other debt relief professionals in order to decrease their liabilities before they become a formidable obstacle.

A well-balanced debt to income ratio provides borrowers with an opportunity to gain leverage in the negotiation of loan amounts or interest rates if other elements are not in their favor.  Since it is often utilized to calculate the mortgage amount for which an applicant qualifies, this figure plays a central role during the financing of a home.  The debt-to-income rate enables consumers to better ascertain the percentage of income that will be available for insurance, taxes, interest, and principal- often dubbed “PITI”- as well as other monthly mortgage obligations.  According to experts, the aggregate sum that consumers allocate to mortgage payment or PITI should not be higher than 28% of their gross income.

Prospective borrowers may employ online calculators to determine their debt to income ratio.  For loan purposes, gross income or pre-tax earnings are always utilized in calculating gross income.  One method of obtaining the debt-to-income rate is to add up all the housing expenses, which include home insurances, taxes, and mortgage payment, and divide these debts by the borrower’s gross monthly income.  A second method involves calculating the total sum of monthly liabilities typically referred to as recurring debt, which encompasses home equity loan payments, rent/mortgage payments, credit card bills, child support obligations, and auto loan payments and dividing the number by the borrower’s gross monthly income.  Monthly expenses such as gas, utilities, entertainment, and groceries are disregarded when calculating the debt-to-income rate.  Gross income does not consist solely of the consumer’s yearly gross salary but also of child support or alimony, steady income derived from interest and dividends, tips or commissions, as well as overtime and bonuses.  The final figure is referred to as the back-end ratio.