How to Calculate Your Debt-to-Income Ratio | CapWay
- The debt-to-income formula is a great scorecard to manage debt.
- Debt payments of less than 10% of your income are within the healthy range.
- Debt payments worth 15% or more of your income can be dangerous and unsustainable.
When you apply for a loan, one of the first steps your lender will take is to check if you can repay the loan. The larger the loan amount and the longer the loan period, the more extensively the bank will evaluate your paychecks, spending habits, and credit history.
In addition to reviewing your cash flow and repayment history, the bank will analyze your current debt and compare your total debt payments to your income. The valuation of this comparison is called the debt-to-income ratio (DTI). Let’s take a closer look at how DTI ratios are calculated and how they can help you manage your finances.
Calculating Your Debt-to-Income Score
Debt-to-income formulas vary by lenders. Generally, all lenders add monthly debt payments and divide them by your monthly income to determine your financial health. Expenses such as rent, utilities, and entertainment are not owed to a lender. Lenders often exclude mortgage principal and interest from the calculation.
How to Use Your Debt-to-Income Ratio
So now that you know how to calculate a debt-to-income ratio, let’s put your money to the test and compare your after-tax income to your monthly debt payments.
Add up all your monthly debt payments. These amounts include your credit card debts, personal loans, student loans, medical debt, car loans, furniture loans, and even payday loans. Gathering old bank statements and credit card statements will help in determining your debt payments.
Recommended Read: What is a Payday Loan?
Divide your total monthly payments by your take-home pay. Your take-home pay is your income after taxes, required withholdings, and any other deductions. You can calculate your monthly after-tax income by dividing the annual after-tax income shown on your W2 statement or 1099 statement by 12.
The resulting number from this calculation explains what percentage of your take-home pay is being used to pay the debt. A lower number is your goal.
Image Credit: dizain / Shutterstock.com
Interpreting the Results
The DTI ratio provides a useful tool to gauge how much debt you have, and whether it is safe to incur more debt or to instead press the brakes and reduce your balances. A small DTI number means that a lower amount of money is being used to pay off creditors, and more is being kept to cover your living expenses. The smaller the percentage of money being used to pay creditors, the more that can be used to reach your financial goals.
If your DTI score is 0.10 or less, this means that ten percent or less of your income is spent on debt payments, representing a healthy debt level. For example, if you have $200 in monthly debt payments and $2,000 in after-tax income, dividing $200 by $2,000 equals 0.10, translating into 10% of your income is spent on debt payments.
If your DTI score is between 0.11 and 0.14, meaning 11% to 14% of your net income is spent on debt payments, think of this range as a caution flag, and slow down on taking on any more debt. For instance, if you have two credit cards, consider reserving one for emergencies, and use it rarely and only when required.
If your ratio is between 0.15 and 0.18, or 15% to 18%, this represents a hefty percentage of the debt. Therefore, your financial plan should focus on paying off your balances and steering clear of any new debt.
If your DTI score is above 0.19, focus on aggressively paying down your balances. If you’re stumped on how to get started, a trained financial coach can help outline a strategy.
If your ratio is close to or exceeds 30%, consider this the red or danger zone, with your debt approaching an unsustainable level. Again, a certified financial planner or other debt management professional can help you review your options.
Digging into the Numbers
Let’s look at an example to see a DTI ratio and financial plan in action.
Image Credit: best pixels / Shutterstock.com
Meet Sean. Sean brings home $2,000 a month after taxes. He would like to buy a house one day but first wants to make sure that he understands his spending, and gets on top of any debt issues. Sean’s monthly debt payments are as follows:
- Student loan payments of $125
- A department store card payment of $25
- A personal loan payment of $50
- A credit card payment of $50 per month.
Recommended Read: What's the Best Mortgage? | Picking Loans
These payments add up to $250 a month. In addition, Sean sometimes makes extra payments on his credit and retail store cards. However, since the DTI ratio focuses on required debt payments, Sean excludes these additional payments from the formula.
Sean divides his $250 of required debt payments by his after-tax income of $2,000, yielding a result of 0.12. This means 12% of Sean’s income goes towards debt payments. He knows he’ll have to reduce this number when he applies for a mortgage. So Sean decides to devise a plan to pay off his personal loan early, and put those funds toward the savings account he has already started for his mortgage down payment.
The Money Wrap-Up
The debt-to-income formula is a great benchmark for checking whether your debt payments are in the green, yellow, or red zone. Debt payments that comprise less than 10% of your income represent a healthy level of debt. On the other hand, debt that consumes 15% or more of your net income can be dangerous and even unsustainable at levels upwards of 30%.
You can use your DTI score to brainstorm strategies to increase your income and reduce your debt. Before making any new purchases, particularly those requiring a loan or using your credit card, use the DTI formula to calculate how this new debt will affect your score. For example, if upgrading your cell phone with a newer model will add $25 in monthly credit card payments, causing your DTI score to rise above 20%, consider pressing pause on this purchase until you increase your income or lower other debt payments.
Main Image Credit: DAMRONG RATTANAPONG / Shutterstock.com