A low debt to income ratio is the second most important consideration when applying for credit. Whilst an individual's FICO credit score rating is largely determined by their repayment history (35%), the percentage of debt a person has in relation to their gross income accounts for up to 30% of a FICO score. It is a very important criteria for lenders as it indicates how financially stretched that person is. The higher the percentage, the greater the likelihood of the borrower defaulting on the terms of the agreement.
How to Calculate a Debt to Income Ratio
- Add up all monthly personal debt repayments, including the car, loan, medical, student loan, alimony, child support and credit card payments. There is no need to incorporate regular household bills (such as groceries, gas and electricity) into this calculation.
- It is necessary to add up all of the house payments, such as the cost of paying the mortgage, home insurance and any related property taxes.
- Add these two figures together and divide the total by the gross household income.
Calculating a Debt to Income Ratio Example
- Personal debt repayments: car loan ($300), personal loan ($150), child support ($300) and credit card debt repayments ($400). Total = $1,150.
- House payments: Mortgage ($1,500) and home insurance ($100). Total = $1,650.
- Debt repayments ($1,150) + house payments ($1,650) = $2,800. This figure is then divided by gross household income ($7,000). The debt to income ratio is 40%.
What is an Acceptable Debt to Income Ratio for Lenders?
Whilst not written in stone, someone applying for credit should have a ratio of 36% or under. Those with a figure that is higher will either have their credit application rejected or will face a higher rate of interest. As already alluded to, this is because the higher incidence of default. The exceptions to the rule are the Federal Housing Authority mortgage and Veterans Administration mortgage which allows a ratio of up to 41%. The lower the applicant's ratio, the more likely they are to be accepted for credit.
A debt to income ratio is an important determinant in relation to whether an individual applying for credit will be accepted or not. In order to get approval for a loan, credit card or mortgage, it will be necessary to find a way to reduce personal debt repayments (pay them off) or increase income (work overtime or get a second job). This objective could also be achieved by taking out a debt consolidation loan and reducing the overall monthly debt commitment. Long term affordability is a critical issue for all parties.
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