When a person’s personal economy is in turmoil, it is common for debt to mount while income either drops or stagnates. When the going continues to get tough, more credit may be needed either through extended lines, or new ones.
Potential creditors, such as Bank of America or the local car dealership, will offer or deny such lines based on a person’s debt-to-income ratio, or DTI.
Figuring a Person’s Debt-to-Income Ratio
The average person might think of debt as the entire amount borrowed compared to the entire amount earned. For example, if a person earning a yearly income of $90,000 has the following debts:
- Home mortgage – $210,000
- School Loan – $30,000
- Auto loan – $20,000
- Credit card – $3,500
- Credit card – $2,500
Then it could be falsely concluded that their debt ($266,000) to income ($90,000) ratio was just under three, meaning $3 borrowed for each dollar earned.
Creditors, however, look at it in terms of the monthly obligations (also called a minimum payments) versus monthly income. Using the example above, it might look more like this:
- Home mortgage – $1,500
- School Loan – $300
- Auto loan – $420
- Credit card – $42
- Credit card – $35
This means that the person above has a DTI of $2,297:$7,500, which is just over .3, meaning that 30% of this person’s earnings are called for at the start of the month, and he has the rest to live off of.
What is a Healthy Debt-to-Income Ratio?
Lendingtree.com’s article titled “Calculating Your Debt-to-Income Ratio” notes that a lender’s maximum DTI is not to exceed .64, meaning that a person should not borrow more than $64 for each $100 earned.
It goes further to explain that a home payment should not exceed 28% of a person monthly income and that other debts should not total to exceed 36%, though there are some exceptions in cases of VA home loans.
But these numbers are subjective. For example, if one was to ask financial guru Dave Ramsey, he would strongly urge the person in the example above to utilize a debt snowball to bring his DTI down to zero.
Flaws in DTI
Debt-to-income ratios are flawed, and in a way that could prove harmful to someone calculating without the following knowledge.
The income used in DTI measurements is income before taxes. So, while the $7,500 used above may be the money that that person actually earned, he’ll only be able to access 72% of it since 28% will be taken out in federal income taxes, leaving his DTI to be $2,297:$5,400, or about .45.
Despite his high income, $45 of every $100 (at a minimum) will go to creditors.
Knowing one’s DTI is crucial for understanding short-term financial health. It can be found by keeping cash flow statements, which will help one keep a closer eye on the long-term financial health found in a balance sheet.