While there are many different opinions as to how much debt is too much, the two ratios below are the most widely used measures of how much debt is manageable. These ratios are also known as debt to income ratios (DTI). Many of you are reading this and other personal finance blogs in an attempt to dig out of debt. Others are reading to improve their financial stability so as to avoid taking on future debt.
But sometimes, debt is inevitable. For instance, most people are not in a position to purchase a house with cash. If you find yourself needing to carry housing, auto, student loan, credit card or other debt, it is important to make sure that you do not get in over your head with debt payments. After all, you need to use the majority of your income for current living expenses as well as saving for the future.
Front End DTI Ratio
Front End DTI Ratio measures the ratio of your housing costs to your gross income. To calculate it, add up your total housing costs (mortgage principal, interest, insurance, and taxes) and divide that total by your gross income. If you rent, your housing costs are simply your rent payments plus any insurance premiums. Condo or co-op owners should include any fees. You can consider housing costs and income on a monthly or annual basis – just make sure you use the same time period in both the numerator and the denominator!
Here’s the formula written out:
(Mortgage Principal + Interest + Insurance + Taxes + Fees)/(Gross Income)
The standard target for this ratio is less than or equal to 28, meaning that your total housing costs are no more than 28% of your gross income.
Back End DTI Ratio
Back End DTI Ratio measures the total ratio of your housing plus all other debt payments, including those for credit card debt, student loan debt, auto loans, etc. To calculate it, take the numerator from Front End DTI Ratio and add all other payment amounts. Again, you can do this on a monthly or annual basis, then divide the total by either your monthly or annual gross income.
The formula for housing ratio 2 is:
(Principal + Interest + Insurance + Taxes + Fees + CC payments + Student Loan payments + Other payments)/(Gross Income)
The standard target for this ratio is less than or equal to 36, meaning that your total housing costs and other debt payments are no more than 36% of your gross income.
Note that the combination of the two ratios means that your non-mortgage debt payments should be no more than 8% (36% – 28%) of your gross income. For a person with an annual income of $40,000, this amounts to $3,200 per year, or less than $300 per month.
How Debt Ratios are Used
Mortgage lenders will use these ratios when qualifying you for a new mortgage or a refinance. In the past, they might have increased your interest rate if your ratios were higher than the targets. These days, with credit being as tight as it is, lenders are sticking to the traditional ratios
Banks and other private or institutional lenders may also check these ratios before extending credit, or use them to limit the amount of credit they are willing to qualify you for. You can use them to check whether you have too much debt, as seen by the housing and finance industries. You can also solve backwards to see how much debt you can reasonably “afford” to take on – and how big of a mortgage you can truly handle. This will help you avoid buying “too much house.”
Improving Your Ratios
If you run the numbers and your personal ratios fall outside the above targets, you can take steps to improve them.
- Start by making a commitment to stop taking on new debt.
- Then formulate a plan to pay off your consumer debt.
- Next, consider refinancing your mortgage or downsizing your house to lower your total housing costs.
- Finally, look for extra income to maximize your debt payments.
How do your ratios match up to the targets? Let us know in the comments!
Photo by Andres Rueda.