There are many unintuitive systems and statistics within banking. But above all of those, the most confusing is your “debt-to-income ratio”.
But what is debt-to-income ratio?
Debt-to-income ratio is the result of a math equation: First, take the amount of debt you have to pay every month. This includes house payments, car payments, student loans, medical bills, basic utilities, and rent. Add them all together and you have the “debt” part of the equation.
Then, add together all your monthly income sources. Banks will only care about your “official” sources of income—that is, those which are subject to taxes. That gives you the “income” part of the equation.
Now, divide the “debt” value by the “income”. If your income is greater than your debts, you will get a decimal point. For instance, if you have $3,000 in debt every month, but make $10,000 a month, this will divide into .30.
That .30 means that 30% of your income is tied up in debt. That percentage is your debt-to-income ratio.
But what happens if your debt is greater than your income? Well, to begin with, the number you will get from dividing “debt” by “income” will be above 1. This is a problem as far as banks are concerned.
Most banks will not give loans out to anyone whose debt-to-income ratio is higher than 43%. This includes mortgages, auto loans, and student loans.
Why did they pick that number? No one really knows, but it has been that way since the 80s. Whoever made the calculation that decided 43% was a red flag has long since faded into history.
While the reasoning behind the exact number is unknown, the reasoning behind having any kind of number at all is understandable. After all, banks have to have some method of determining your ability to pay off a loan.
Ratioing your debt with your income is one of banks’ primary methods of determining the viability of giving you loans. This means that it is an important factor in both a person and a business negotiating with their bank.
So, how do you manage such a thing? How do you keep your debt and income in a place where you can get the loans you need to make the moves in life you want to make?
It is easy to think of both your debts and your income as immovable things. This certainly feels true, but it is not always the case.
Remember that “debt” and “income”, in these cases, are both calculated before taxes and other things that might affect that total output of your income.
This means that if you wish to set aside more out of your income to pay your debts, it won’t affect this ratio. Paying your debts off doesn’t actually affect the ratio, but it can affect your bank’s willingness to look past the ratio.
Ultimately, it’s one factor among many in negotiating with your bank. It is not the final word.