You may have heard the term Debt to Income Ratio (DTI) being tossed around the water cooler at your work, school, and perhaps even the news. When I first heard this phrase I was scratching my head.
What the heck is a Debt to Income Ratio and what does it even mean?
Is it important?
These were just a couple of the tens of questions that were swirling through my head. I hadn’t even heard of it before I had started my journey towards my freedom of debt, and until recently, I did not realize the importance of understanding it. It is one of those things that no one really talked about (like religion or politics), and this is a major issue. So let’s break down this daunting topic and shed some light on what the ratio is and how it relates to you.
To start, your debt to income ratio is basically how much money you owe versus how much money you make (before taxes). If you were to write it out in an equation it would look like this:
money owed (debt) / money you make per month(paycheck) = debt to income ratio (%)
For example, say you owe the average car payment in the US of $500 a month and you bring in $1,000 a month. Your ratio would be 50%!
Is that a lot?
50% certainly sounds like a lot. Especially when talking about paychecks. In fact, in order to qualify for an FHA loan (typical loan for mortgages) you are allowed a maximum DTI of 43%! I dove a little deeper to try to find an answer and as it turns out, I didn’t have to go very far before I found a set of ranges on the Wells Fargo Website.
Here is what they suggest as guidelines:
35% or less: Looking Good – Relative to your income, your debt is at a manageable level.
You most likely have money left over for saving or spending after you’ve paid your bills. Lenders generally view a lower DTI as favorable.
36% to 49%: Opportunity to improve.
You’re managing your debt adequately, but you may want to consider lowering your DTI. This could put you in a better position to handle unforeseen expenses. If you’re looking to borrow, keep in mind that lenders may ask for additional eligibility criteria.
50% or more: Take Action – You may have limited funds to save or spend.
With more than half your income going toward debt payments, you may not have much money left to save, spend, or handle unforeseen expenses. With this DTI ratio, lenders may limit your borrowing options.
According to the bank/lenders website, a DTI ratio of 50% means that you need to do something to lower it before they will lend you more money. This means that they think you are too big of a risk of not paying them back. To me, a person living at or above 50% is living in a financial crisis!
Don’t worry, I would never live above a 50% DTI ratio.
The scary part of this story is that there are many people across the globe that are living with a DTI ratio over 100%! Quite simply put, a person living as such is spending more than what they are making. It doesn’t matter how much money you make, what demographic you come from, or what you do for a living. If you spend more than you make then you are living in financial crisis! It’s just math!
The funny part is when you try to look up what a “good” DTI ratio would be, there is no concrete answer. Instead, you find a bunch of articles and websites that dance around this question without giving you a solid answer. Banks and lenders are in the business of selling you debt. Why would they want you to borrow as much as you can so that they can keep you in payments forever? To them it’s just good business.
So, what is a good DTI ratio? I say a big fat ZERO!
Think about it. If you don’t owe anyone any money then you would hit that goal of 0%. That would mean that you would get to keep ALL the money you make (less living expenses of course)! Instead of spending that $500 a month on a car, you could put it into a 401k or Roth IRA and retire comfortably! Or you could save up and take that trip to Europe you’ve been talking about.
Summary: Your debt to income ratio can be found by:
- Adding all your monthly debt payments together
- Divide them by your monthly income before taxes.
The higher the ratio, the less money left over for you to live on, less to reach your own fiscal goals, and even the ability to retire. There is no good DTI ratio, and there are quite a few people living beyond their means as they are spending more than they make!
By staying out of debt, we stop funding the dreams of others and can start saving for our own. It may seem like you have a long road before you can be free from this ratio, but it’s worth it! Join me in bringing that ratio down to ZERO and start dreaming again!
What are your thoughts on the DTI ratio? Let me know in the comments. If you like what you read, please be sure to hit the Like button. If you’d like to be notified when I make a new post please subscribe!