What is a Good Debt to Income Ratio?

November 13, 2012

debtA common question amongst potential home buyers is what a good debt to income ratio for the loan underwriting process. As important as this question is for home buyers (or those looking to refinance their loans) it isn’t just for this group of people. Everyone should know what a good debt to income ratio is for their personal finances.

What is Debt to Income Ratio?

To understand what a good debt to income ratio (also known as DTI) is we must first understand what this ratio calculates. You need to know two things to accurately calculate your debt to income ratio:

  • Your total debt.
  • Your total income for a given period of time.

When you are calculating your total debt you want to look at everything like a home mortgage, student loans, car loans, credit card debt, and medical debt. If you owe money to anyone or any financial institution, you need to account for that in your total debt number.

For the ratio’s purpose you’ll want to know what your debt payments are each month as well. This is the number you will compare to your income, but it is still good to know what your overall debt load is as well.

Your total income should be what you make in a month. This is gross income so don’t worry about what’s left after your health insurance, 401k, and taxes come out of the check. (Although if you want to calculate a debt to income ratio after all of this it certainly doesn’t hurt.)

An Example Debt to Income Ratio

Here’s an example to show you how to calculate the ratio.

An individual has the following debt:

  • Home mortgage of $900 per month including escrow and taxes
  • Car loan of $225 per month
  • Student loan payments totaling $300 per month

Their total monthly debt payments come to $1,425.

The same individual makes $4,200 per month gross. That is equivalent to $50,400 over an entire year.

To calculate this person’s debt to income ratio, you simply divide the monthly debt payments by the monthly income ($1,425 divided by $4,200).

The result is 33.93%. This means that about 34% of every dollar that person makes must go to debt payment and that’s before taking into consideration taxes, health insurance, and retirement through their employer.

What is a Good Debt to Income Ratio?

Of course the best debt to income ratio is 0%. That would mean you are debt free and able to use every single dollar you earn toward your daily spending and savings goals like retirement.

However, we all know that getting to 0% debt is really difficult. So what do mortgage companies look for?

Ideally you want to be below 35% debt to income ratio. In the past you could get away with higher debt loads and get approved with a ratio in the 38% range, but that isn’t as common after the financial and housing crisis. Getting below 30% is really good, and getting under 25% is great.

Why Lenders Want a Lower Debt to Income Ratio

So why do lenders want to see less than 35% (or ideally less than 30-33%) on your debt to income ratio? Let’s go back to our example.

Our individual has $1,425 in debt payments per month and $4,200 in gross income. Let’s now take into consideration those other costs like tax and health insurance. Let’s roll taxes and health insurance together for an additional 25% taken out of your check plus another 5% toward retirement in a 401k.

Here’s how the math works:

  • $4,200 in gross income
  • ($1,050) in taxes and health insurance
  • ($210) in retirement
  • ($1,425) in debt payments
  • Net: $1,515

So you have about $1,500 to handle all of your other expenses: groceries, gas, car insurance, eating out, entertainment. There’s enough money left over to cover those items.

Now let’s look at someone with a 50% debt to income ratio. The numbers are starkly different:

  • $4,200 in gross income
  • ($1,050) in taxes and health insurance
  • ($210) in retirement
  • ($2,100) in debt payments
  • Net: $840

That’s a huge difference and likely unsustainable in the long run. This is exactly why lenders want to see as low a debt to income ratio as possible.

So while it might not be possible for you to get down to 0% debt to income, the lower the number the better off your finances are.

What’s your debt to income ratio? Are you happy with it? Leave a comment!

Last updated by .

Kevin

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Kevin
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He's building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, ING Direct, and many others.

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Comments

2 Responses to What is a Good Debt to Income Ratio?

  • Big Cajun Man

    Good debt? No such thing, debt is debt (I think it’s all evil, but that is my opinion). Good debt is simply marketing speak.

    Sustainable debt really sounds like something to control the serfs with too.

    Sorry, I’ll get off the soap box here, very good article, just pushed a few of my buttons.

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