There are many factors that lenders consider when deciding whether or not to extend credit to someone applying for a loan. Credit score, down payment, and the purpose of the loan are all factors. There is one factor that is looked at probably more closely than any other though, and that is the debt to income ratio. This is the way that a lender determines how likely a consumer is to be able to make timely payments for the life of the loan. Understanding how the debt to income ratio is determined is the key to making sure that you're in a position to obtain credit in the future.
When you sit down in front of a creditor, you will most likely be asked a series of questions. The lender is looking for the elements in your financial life that comprise your debt to income ratio.
What is your monthly income, if you add up all the sources of money that comes into your hands each month? This answer is the income portion of the formula.
What payments are you liable for each month on money you've borrowed in the past, including mortgages, auto loans, credit card debt, student loans, and all other monthly obligations? This is the debt portion of the equation.
The debt to income ratio, then, looks like this:
Debt to Income Ratio = Total Liabilities/Total Income
A lender has a target number in mind for individual's looking for a loan. People with a high debt to income ratio are unlikely to find a creditor willing to make a loan to them, since as debt payments already take a large amount of your monthly income to pay, you're unlikely to be able to continue making all of your payments long term. If a lender is willing to lend up to a point where your debt to income ratio is 38%, but no higher, then the credit you qualify for may be considerably less than what you're seeking if your debt to income ratio is already 35%.
There are only two ways to reduce your debt to income ratio. Your first choice is to increase your income. A second job or a career change maybe in order to qualify for a higher amount. Your second choice is to reduce your debt obligations. Paying down balances doesn't matter here unless you can completely pay off a debt, since the ratio is based on your monthly payments, which stay constant on most types of debt. For example, paying off half of your mortgage balance will not change your monthly payment or your debt to income ratio. However, refinancing and reducing your monthly payment will reduce your debt to income ratio (even though it could increase your overall loan balance).
Understanding the debt to income ratio will help consumers stay positioned to obtain financing when they need it and to keep their debt levels manageable. There are several free websites that will help you calculate your debt to income ratio.
