Debt to income ratio is an important value for both creditor and debtors because it is one of the factors considered by lenders to determine whether a person applying for a loan could really afford to repay the loan. To calculate your debt to income ratio, take the total amount that you will be paying for all debts and divide this by your total monthly income.
When you are applying for a loan, the lender will estimate your capability to pay by adding the monthly payment for the loan that you are applying for to your existing monthly payments for debt and then dividing this by your monthly income.
There are actually two kinds of debt to income ratio.
- The front-end ratio is employed by mortgage lenders and this is computed by obtaining your total housing costs and dividing it by your gross monthly income. Total housing costs take into account the mortgage payments, taxes and insurance.
- The other type of debt to income ratio is the back-end ratio, which is bigger than the front-end ratio because it takes into account all of your debt payments every month.
The higher your debt to income ratio, the higher the chance that you will default on your debt payments in the future! Therefore, banks and lenders usually reject a loan application by a person with a back-end ratio that is more than 36 percent.
Debt to income ratio can also play a significant role when you are applying for a loan and your credit score is not that high. You may be able to negotiate better interest rates if you can show that you have a low debt to income ratio.
For personal finance purposes, watching your debt to income ratio would also be helpful. For example, you might reconsider purchasing an appliance on installment if it pushes your debt to income ratio to an unacceptable level.
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