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Before applying for a mortgage, car or personal loan, you need to know if you earn enough income every month to pay back your new debt.
Fortunately, there is an easy way to do this: You just need to calculate your debt-to-income ratio.
Lenders will calculate this ratio every time you apply for a loan. They do this for a simple reason: They want to make sure that you will not be so overwhelmed with debt that you will not be able to repay their loans.
You should determine your debt-to-income ratio yourself to make sure that you will not be placing too much of a financial strain on yourself when you take on new monthly debt. You do not want to take on a new mortgage or car loan only to discover two months later that you do not make enough income each month to afford the payments.
Lenders typically rely on two debt-to-income ratios, depending on what type of loan you are seeking.
Your front-end debt-to-income ratio looks at how much of your monthly income that your total housing payment — including principal, interest and taxes — consumes. In general, lenders want your monthly housing payment to take up no more than 28 percent of your gross monthly income, your income before taxes are taken out.
Your back-end debt-to-income ratio looks at how much of your gross monthly income that all of your debts — everything from your mortgage payment and car loan to student loans and minimum monthly credit card payments — take up. Lenders want your total monthly obligations to equal no more than 36 percent of your gross monthly income.
Your personal debt-to-income ratio
Calculating how much you should be spending on monthly debt payments is pretty straightforward. First, determine your gross monthly income. If you make $36,000 a year, your monthly income is $3,000. Next, multiply that figure by 36 percent. This will give you $1,098. This means that you should be spending no more than $1,098 each month on debt payments.
What if you are spending more than this? You’ll want to calculate your back-end debt-to-income ratio to determine how much you are paying on debt each month.
First, calculate your total monthly payments. You can do this by digging up your recent credit card bills, mortgage loan statement, car loan statements, student-loan bills and any other loan payments you make each month. Don’t include household expenses such as the money you spend on groceries or utilities.
Once you’ve determined this figure, divide it by your monthly gross income. This will give you debt-to-income ratio. For instance, if you are spending $1,000 on debt each month and your gross monthly income is $2,500, you have a back-end debt-to-income ratio of 40 percent, which is too high.
You have two options when it comes to reducing your debt-to-income ratio. You can either boost your gross monthly income or reduce your monthly expenses.
Whatever approach you take, know that lenders of all kinds will pay close attention to your debt load. Make sure, then, that you do the same.