Ideal Debt-to-Income Ratio And why it’s important to manage
Debt-to-income ratio refers to a formula that compares the amount of money you owe to the amount of money you earn. It’s an important formula in the grand scheme of your financial health, yet few people can even recite their figures. But before tackling what it’s used for and what the ideal ratio is, let’s take a step back… in time.
In decades past, at least in the United States, a banker was a member of the community. Everyone knew him — because it was almost always a man — and he knew everyone in town. When the baker needed a loan to expand his store, pay off a debt or buy a new oven, for example, he went to the banker. The banker, being a good judge of character, deemed the baker a good risk or a bad risk and set the interest accordingly. If the baker were a known rascal, maybe the banker wouldn’t loan him any money.
Obviously, that’s not the way it’s done today, and mostly for good reason. First of all, bankers don’t own their banks anymore, so it’s not up to them how to make loans. Banks now have investors; investors want assurances. And so bank loans now come with reams of paperwork that are meant to make the loan process “safer” for the banks. Character has little or no bearing on whether you get a loan anymore.
Determining Your Credit-Worthiness
Today, mortgage lenders, including independent mortgage lenders like Prime Mortgage Lending of West Asheville, use formulas in an attempt to reduce your credit-worthiness down to a single number. It’s a bold attempt to take personality and relationships out of the equation. These formulas take in all kinds of relevant information — measurable data — to try to figure out just how likely you are to pay back the loan with interest.
Your credit rating is just such a number. It combines your credit history, income, spending habits, saving habits, level of current debt and how often, if ever, you’re late paying your bills into complex calculations that produce a single number signifying your credit-worthiness. With this magic of mathematics, banks and credit agencies quickly size you up when you apply for a loan.
How the Debt-to-Income Ratio Fits
Returning to the definition of the debt-to-income ratio, you can begin to understand how valuable this information can be to a banker investigating your credit-worthiness. If you owe too much money, paying it off takes up most of your income, making you a bad risk for a new loan. If you don’t owe much compared to how much you make, you have financial “room” for more debt, making you a good risk.
Obviously, the best way to tilt your debt-to-income ratio is to make more money. A higher income will make any debt seem smaller by comparison. Of course, raising your income is easier said than done. The second way to improve your debt-to-income ratio is to reduce your debt: pay it off.
Usually what happens is a little of both. Over time, you advance your career, earning more as you pay off your debt. The result is a better debt-to-income ratio, which improves your credit score and allows you to buy that bigger house or newer car.
The Ideal Ratio
In the mortgage lending industry, it’s best if your debt-to-income ratio is below 43 percent. Why 43 percent? Studies have shown that people with a ratio below this figure are more likely to pay off their loans than people above that number. So before you shop for a new house or a mortgage, do your best to make sure your debt-to-income ratio falls below 43 percent if you want to get the best terms for your loan.
If you’ve reached a 43 percent ratio in your finances, you’re deemed fiscally responsible. Here are some examples of this magic number in the real world:
- If you earn $3,000 per month and are only paying $1,290 a month toward your debt — including your credit cards, student loans, car loans, existing mortgage and any other loans you’ve acquired.
- If you earn $5,000 a month and have less than $2,150 in monthly debt payments, you’re below the 43 percent debt-to-income ratio.
- If you only earn $1,500 a month, you can pay no more than $645 a month in debt, which is why not many people making $1,500 a month can afford a house.
How Do You Rate?
To find out more about your debt-to-income ratio and discover if you qualify as a good candidate for a mortgage, contact Zachery Adam at Prime Mortgage Lending of West Asheville or call 828-242-4780. Zack loves helping people get into new homes. He’ll also help you figure out your debt-to-income ratio.