What is Debt-to-Income and How does it Affect Me?

by Julie Peebles

Debt to Income is a term you’re going to hear nearly every time you apply for a loan, though it’s seldom explained. Let’s take a minute to review what it is, what it isn’t and how it impacts you.

How is Debt-to-Income Calculated?

Debt to income, or DTI, is a ratio used to determine how much house you can afford. Here’s how it works:

Take your annual salary and divide it by 12. This is your gross monthly income. Multiply this amount by .36 (36%). This is the recommended maximum DTI ratio for the average borrower. To figure out how much house you can buy, subtract your current monthly payments that report to credit from this dollar amount. For example, if you make $60,000 a year, here’s the math:

$60000 / 12 = $5000 (so $5000 is your gross monthly income)

$5000 x .36 = $1800

Now, let’s say you have a student loan, a credit card and a car payment; subtract these:

Gross Income $1800

Car Payment -$350

Student Loan Payment -$100

Credit Card Payment -$50

This is the house payment you can afford. In this example, $1300.

What Does Your Debt Include?

Nearly everyone has debt but not everyone defines it the same. Here’s what it means to a lender: financial obligations that report to credit. Let’s break it down.

What counts?

  • Credit cards
  • Student loans
  • Mortgages
  • Store credit (furniture, appliances, etc)
  • Car payments

What else could count?

Court-ordered obligations like child support, separation maintenance and alimony are counted as debt when applying for a mortgage.

What doesn’t count?

Unless you are applying for a VA (veteran) loan, other monthly payments do not count towards your DTI. Things like utilities, child care, insurance and phone bills are not calculated. This is why a 36% DTI is considered a healthy ratio, to account for these expenses and other costs of living like entertainment.

Other Factors to Consider

Let’s go back to the above example, on paper, $1300 looks like a lot of money to buy a house with. Before you get too excited, there are three other factors to consider:

  • Taxes and insurance need to be budgeted into your monthly payment. Let’s say these are $2400 a year for the home you want to buy, that’s another $200 a month we need to subtract from what’s available which brings our total house payment down to $1100.
  • Mortgage insurance (commonly called PMI). If you are unable to buy a home with a down payment of 20% or more of the asking price, you will have to pay mortgage insurance on your loan. The amount can vary, but let’s estimate $100/month for this. Now the amount of house you can afford drops to $1000/month.
  • The future What are your plans for career and family? Are you in a field your income can continue to increase? Do you have plans to get married, possibly taking on a second car payment or have children? These are all expenses you should take into consideration when determining how big you want to go when you buy a home.
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