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What Is a Debt-To-Income Ratio?

Learn about debt-to-income ratio in this Howcast finance tutorial with expert Gregory McGraime.

Transcript

Your debt-to-income ratio is really important when you're applying for a loan, and basically that's the way the lender is going to decide whether you can afford to make the payments that the loan might entail. So let me give you an example. Let's say I want to buy a home and the lender is trying to say ""Can I afford the loan?"" so what are they going to do? They're going to calculate my debt-to-income ratio and I'll give you an example. And there are a lot of different types of ratios out there, but in the most basic sense, I know ratios sound complicated with a lot of math but let me give you an example. The bank is going to take my home payment that we're projecting, and let's say I'm going to spend $2,000 on that home payment, they're going to put that number on top. And then on the bottom, they're going to take my pre-tax monthly income, so let's say I make $60,000 a year. Before taxes that's $5,000 a month, so they're going to put $5,000 on the bottom. So I have my $2,000 home payment over my $5,000 income. My debt-to-income ratio in that example is 40%. Now 40% is really high. In general, the guideline is to try and keep your home ratio at 28% or lower, so that lender is going to use that debt-to-income ratio as a way of determining whether or not I can qualify for that loan.

The way I want you to use the debt-to-income ratio, because I do want you to calculate it for purchases that you're considering, I want you to make sure that that purchase or that borrowing or the mortgage that you're getting is affordable for your situation, because what can happen sometimes, sometimes banks are trying to sell you a product and they're less concerned about your overall financial situation and more concerned with making a commission on that product. So when you're applying for a mortgage for example, I want you to calculate the debt-to-income ratio and make sure, compare it to that 28% threshold to make sure it's affordable. The other reason debt-to-income ratios are so important, is that can help you when you're looking at your financial situation, see where your challenges are. You know, if I calculate my housing ratio and that debt-to-income ratio for my home payment is very high, let's say it's 40%, I can probably scrimp and save all I want going out to get coffee. The real issue is my home payment. On the other hand, if I calculate that debt-to-income ratio for my home and it's very affordable and I'm still having trouble making financial progress, then maybe I do need to focus on all the other spending side of things in order to really make progress here. So again, debt-to-income ratio is a tool and it can be used by your lender to see if you're going to qualify for the loan, or it can be used by you to help see where your challenge might be financially.

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