Debt to Income

I’m learning so much already. One thing I have heard about several times but never really understood was the debt to income ratio. I kept thinking it must be all of your debts beside all of your income. Since income and debt payments happen over time, I just figured it must not really matter.

It does. It turns out that banks and other institutions calculate our debt to income ratio all of the time because if it gets too high, we are less likely to be able to pay our existing debts much less take on new ones. According to the Consumer Financial Protection Bureau (CFPB), it should be less than 43% Why is the 43% Debt-To-Income ratio important?. According to Jean Chatzky’s book Ageproof it should be less than 36%. I’m guessing smaller is better. Based on some other stuff I’ve heard, 0 is not a good number because it means you have no debt, thus no way to show that you can pay it off. However, I’m sure that 0 is better than 1.

As part of my getting financially smart this year, I am forcing myself to do all of my financial math. It turns out that calculating your own debt to income ratio is not that hard. It is an accounting of your debts to your income, but not exactly the totality of them. For a given month, what are your debt payments compared to your income. This does not mean that you need to add up all of your debts.

Here’s how to do it - and be prepared to recalculate at any time.

1. Make a list of all of your income sources in a month. Write down the dollar value. If your income is erratic, just average the past 3, 6, 9, 12 months - you get to pick this. Use the value before taxes. If you have a salary, just divide it by 12.
2. Sum up all of those monthly estimates. This is your income.
3. Make a list of all of the accounts or things where you carry a balance: car, house, credit card, etc. Write down the dollar cost of making those payments each month. Here’s a tricky part: if you generally pay some value that is different than the minimum requirement, write down both values (this is just for you) - the banks will use something close to the minimum. Include rent if you do not include a mortgage; you have to pay for housing, unless you have some kind of sweet no cost housing deal, like a paid off house. You don’t need to include the cost of services, like insurance and utilities, or consumables, like gasoline and food.
4. Sum up the monthly estimates for paying off your debt. This is your debt.
5. Calculate Debt To Income (DTI) as the debt over the income

Here’s an example: Let’s assume an annual salary of 60,000. Debt payments of 500 per month for a car and 1500 per month for a mortgage. No other income or debts. For this, we have a gross income of 5,000 (60,000/12) and a debt of 2,000 (500 + 1,500). The DTI is 0.4 or 40%. What it means is that our example person has about 40% of their income going to debts and 60% left each month for all other expenses, save debts.

How do you like your number? What can you do to improve it?

Lifestyle can have a lot to do with whether a low DTI will result in an easy comfortable, stress-free money life for anyone. After all, we can spend a lot of money on services and consumables.