Household debt-to-income ratios are most commonly talked about during the process of applying for a mortgage. When people buy homes, or other big-ticket items, lenders review their debt-to-income ratio as a consideration when deciding whether to offer a loan. This ratio is more commonly discussed based on established guidelines for maximum ratio levels, as opposed to household averages.
Debt-to-income compares monthly debt obligations to monthly gross income to determine capacity for taking on new debt. Mortgage or rent is usually the largest debt obligation people have, and this is central to the debt component of the ratio calculation. Also included in the debt amount are monthly car loan payments, monthly credit card minimum payments and any other regular loan payment obligations, according to US News' debt-to-income calculator.
To determine the income portion of your debt-to-income calculation, all of your income sources are totalled on a monthly basis. Your annual gross salary is divided into monthly instalments. Any regular bonuses or overtime income is added. Any other income sources, such as consulting or freelance work, along with alimony or child support are also included, notes US News. To complete the calculation, your total debt amount is divided into your total income amount to establish a percentage of debt to income.
Lenders use your debt-to-income when you apply for a new loan, especially with a new mortgage application. The standard guideline for a conventional loan where you pay at least 20 per cent down on your home is a maximum debt-to-income ratio of 36 per cent. In considering your mortgage, the lender takes 36 per cent of your gross monthly income to establish a cap. Your non-mortgage debt is subtracted from this amount to determine your maximum allowable monthly mortgage payment.
Typically, a debt-to-income ratio 36 per cent or below is considered financially healthy. US News indicates ratios of 37 to 42 per cent are not bad, 43 to 49 per cent require some intentional repairs, and 50 per cent or above likely require aggressive professional debt repair help. Some lenders may flex the 36 per cent guideline for borrowers that put more than 20 per cent down on the home or who have significant assets for financial protection. You should also consider maintaining a lower ratio if you have uncommon expenses like high charitable donations, alimony or child support. In general, a lower debt-to-income ratio means you have higher debt capacity in the future.