Typical Debt to Income Ratio

The debt-to-income ratio is one of the formulas that lenders use in order to judge whether they should lend money to borrowers. For the lender, this is a matter of risk. Lenders are anxious to keep their profits. They do not want to lend money to anyone who may not be able to pay the loan back. As a result, ratios like debt-to-income are becoming more important in the mortgage application process.

Definition

The debt-to-income ratio shows the proportion of the borrower's debt to their monthly gross income. Gross income is typically found by dividing yearly income by twelve, before taxes and any other expenses. This amount is then compared to all the borrower's liabilities, not only with large loans but also with averaged credit card debt and any other types of debt used. The debt is expressed as a percentage of the gross income. The amount of gross income left after debt must be enough to pay for all normal expenses and taxes.

Best Ratios

Lenders like to see a very low percentage of debt to gross income. The lower, the better for the loan application, since this means the borrower has more income to help pay debt. So, an ideal debt-to-income ratio comes to 10 percent. This is very rare, especially in the United States. Most people keep their ratios around or below 35 percent, but nowhere near 10 percent. For a borrower anxious for a loan, 20 percent may be a more reasonable goal that still has a positive effect on the lender's decision.

Danger Ratios

Ratios become dangerous when they start edging above 35 percent. Of course, lender decisions depend on the economy: in a contraction, lenders will want a lower ratio. Many lenders may be prepared to lend up to the mid-40s, but not beyond. Debt-to-income ratios of 50 percent or more are very dangerous and indicate the borrower may need to start defaulting on loans in the future. The type of credit you are looking for may also matter. Credit card companies generally accept higher ratios than mortgage lenders.

Improving Ratios

If you do not want a loan application rejection or a high loan interest rate that makes your debt even more difficult to pay off, you can easily lower your debt-to-income ratio: simply cut present debts. Pay off any credit card debt and stop using credit cards. Work to pay off smaller loans that are within your reach and close accounts quickly. This has an immediately positive effect on your debt-to-income ratio.