Having been in the credit industry for the previous 15 years I can assure you that other than your personal credit score, the debt-to-income (DTI) Ratio is the most important factor creditors analyze when deciding to extend you credit. The DTI ratio is the percentage of your gross income that is applied to your current debt.
There are two forms of DTI ratios. The front-end DTI ratio is the percentage of your monthly gross income applied to paying only housing costs, such as principal payments, interest, taxes and insurance. The back-end DTI ratio is the percentage of your monthly gross income applied to all your debt. The back-end DTI ratio is the most commonly used by creditors.
Calculation:
First, add up all your monthly debt obligations to include monthly mortgage payments (principal, interest, taxes and insurance), home equity debt payments, car loan payments, student loan payments, the minimum payments on all your credit card debt and any other minimum payments of your additional liability. Secondly, determine your monthly gross income. Finally, divide the total debt by the monthly gross income figure.
Here is an example:
Mortgage payment $850
Car loan $331
Student loan $230
Credit Card minimum payment $150
Total monthly debt payment $1,561
Monthly Gross Income $5,000 (making $60,000 annually)
Debt-to-Income Ratio 0.3122 or 31.22%
The lower DTI ratio, the better you are able to handle your debt payments. Creditors may offer you greater lending capacity as well as attractive interest rates with a lower DTI ratio. Every lender abides by certain lending guidelines. The smaller community bank vying for your business may be apt to have more lenient lending guidelines to attract you.
For traditional non-conforming loans, such as car loans and credit cards, a lender may not consider you a credit candidate if your DTI is higher than 50%. For conforming loans, such as Conventional and FHA mortgages, a back-end DTI should not exceed 36% and 43% respectively.
Most commercial banks prefer your DTI not exceed 36% of your gross income. Using the example mentioned above, with an annual income of $60,000, you should not exceed spending more than $1,800 per month on your personal debt obligations. With the sub-prime credit crisis now occurring, the guidelines banks use will likely become more stringent.
When applying for additional credit you should be aware of what the additional debt will do to your personal DTI ratio. Besides your personal credit score the DTI ratio is the most important factor with creditors. With a low DTI ratio you will receive better rate quotes on mortgages, lower interest rates on vehicle purchases and even receive better credit card rates. Greater knowledge brings about greater decisions!