How is the debt to income ratio calculated?
ALBANY, NY (NEWS10)- Have you ever tried to apply for a loan or a credit card from your bank and been told that your debt ratio was too high? It’s easy to calculate, but what is the optimal debt-to-income ratio?
Knowing your debt-to-equity ratio can help you avoid surprises before applying for a mortgage or refinancing an existing mortgage, applying for a credit card, car or personal loan.
The formula for calculating the debt-to-income ratio is quite simple. Add up all monthly expenses (mortgage, car, credit card, other bills). Divide your total monthly expenses by your gross monthly income (income before taxes and deductions), then multiply that number by 100.
See how the debt-to-income ratio is calculated for someone who pays $2,000 in bills every month with a gross monthly income of $2,500 in the chart below:
The debt to income ratio in the above scenario is 80%. In other words, 80% of monthly income is spent on bills. Despite on-time payments and a decent credit score, someone with a high debt-to-income ratio is statistically more likely to default on loans or credit accounts, according to the Consumer Financial Protection Bureau (CFPB). This means that they also represent a risk for banks and lenders.
What is a good debt-to-income ratio? Experts and financial institutions like LendingTree, CFPB, NerdWallet, The bank rate, and Wells Fargo said the ideal debt-to-income ratio is between 28 and 36%. It doesn’t matter how much someone earns. If they pay more than 28-36%, it may be difficult to get a loan or a credit card.
Banks and/or credit card companies may also have different requirements. Smaller financial institutions may have less flexibility and require a lower ratio to secure a loan or credit card.
Going back to the scenario above, someone who pays $2,000 in bills would need to gross $5,500 per month to achieve a debt-to-income ratio of 36%. If more than doubling their income was not an option, they could achieve the same ratio with a monthly gross income of $2,500 if they could reduce their bills to $900 per month.