What Is a Debt Ratio used for?

what is a debt ratio used for?

“I hate it when she leaves me hanging!”

While applying for a loan in the past, you may have heard the term “debt ratio.”  What is a debt ratio, and how does it affect your chances at being approved for the loan you need?

A debt ratio, or, “debt-to-income ratio” is a ratio that indicates  the proportion of a persons debt to their total income.  Most of, if not all lenders, look at this ratio when determining whether or not to give final approval on a loan.  In some instances, this ratio is weighed more heavily than a credit score in the underwriting process.  Here’s how to calculate YOUR debt ratio, and here’s why it’s so important to a lender:

To calculate a debt ratio, add up your monthly income, before taxes.  Next, add up you total monthly recurring debts such as mortgage payments, rent, car payments, loans and minimum monthly credit card payments.

Example: Income = $60,000 per year, divided by 12 months = $5,000 of income per month

Recurring Debt = $1,000 rent, $300 car payment, $25 credit card bill = $1,325 of recurring debt

Divide your recurring monthly debts by your total monthly income: $1,325/$5,000 = 26.5%

Statistics show that those with a higher debt ratio run into issues making monthly payments.  As a reference, a mortgage lender typically uses a 43% cut-off when underwriting mortgages.  If you have a higher debt ratio, your lender may look at you as higher risk.  This percentage is important when planning for your future.  The more recurring debt you have, the more difficult it may be to obtain credit when you want/need it the most.  Setting a monthly budget and maintaining that budget are important when planning for your future.  It may prevent you from taking on too much debt.

That’s what a debt ratio is used for.  To read more, check our friends at Investopedia!

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