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Your debt-to-income ratio is a personal finance measure that compares the amount of money that you earn to the amount of money that you owe to your creditors. For most people, this number comes into play when they are trying to line up the financing to purchase a home, as it is used to determine mortgage affordability. (For more information, see Mortgages: How Much Can You Afford? and Are You Living Too Close To The Edge?)
Once financing has been obtained, few homeowners give the debt-to-income ratio much further thought, but perhaps they should. In this article, we will show you how this powerful ratio is used.
How to Calculate
Calculating your debt-to-income ratio isn't hard and it doesn't cost a dime. There are two main ways to calculate this depending on the debts included in the calculation.
The less strenuous way to measure this ratio is to compare all housing debts, which includes your mortgage expense, home insurance, taxes and any other housing-related expenses. Once you have the total housing expense calculated, divide it by the amount of your gross monthly income.
For example, if you earn $2,000 per month and have a mortgage expense of $400, taxes of $200 and insurance expenses of $150, your debt-to-income ratio is 37.5%.
The more encompassing measure is to include the total amount of money that you spend each month servicing debt. This includes all recurring debt, such as mortgages, car loans, child support payments and credit card payments.
When calculating this ratio, don't count monthly expenses such as food, entertainment and utilities.
Gross Versus Net
For lending purposes, the debt-to-income calculation is always based on gross income. Gross income is a before-tax calculation. And as we all know, we do get taxed, so we don't get to keep all of our gross (in most cases). Because you can't spend money that you never receive, the result is a somewhat aggressive picture of your spending ability.
Consider the $2,000 per month gross monthly earnings example. After taxes, at 2006 annual tax rates that imposed a flat rate of $755 plus 15% of the amount over $7,550, that $2,000 per is reduced to $1,731.46 or less (depending on retirement plan contributions and other factors).
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