Your debt-to-income ratio measures how much of your monthly income goes to pay off debt. To calculate it, you divide your total monthly debt payments into your gross monthly income. For instance, if you make $500 per month in debt payments and you have $1,500 in income, your debt-to-income ratio would be a relatively healthy 33 percent. Mortgage lenders use this statistic to determine how large of a loan you can afford, although it is also a useful tool to measure your overall financial health.
The debt in your debt-to-income ratio comes from adding up the minimum monthly payments on all of your loans and credit cards. For instance, if you have a $150 student loan payment, $225 car payment, $50 payment on one credit card, $40 on another, and $35 payment on a store card, you'd have total monthly debt of $500. If you pay $100 on your score card, you'd still count the $35, since the ratio only measures the payments that you absolutely have to make. Remember also that the monthly rent you pay, if any, is considered a part of your debt.
The income part of the ratio is based on your monthly gross income. To find it, add up what your boss pays you, any bonus or overtime you get, and any other income you earn. For instance, if you make $1,400 per month at a part-time job and make $100 of overtime, you would have income of $1,500. Your income is calculated before taxes get taken out.
A Healthy Ratio
Generally, keeping a debt-to-income ratio of 36 percent or less is healthy, according to personal finance author Gerri Detwiler. This should mean that you have more than enough money left over after taxes are taken out and you've paid your bills for the rest of your living expenses. A debt-to-income ratio between 36 and 50 percent can be manageable, but generally leads to financial trouble. If more than 50 percent of your monthly income is going to minimum debt payments, though, you may need help managing your money.
A front-end debt-to-income ratio calculates how much of your monthly income must go to cover the cost of your home, while the back-end debt-to-income ratio calculates how much of your monthly income goes to cover all debt.
The Zero Option
Some pundits, including Dave Ramsey, feel the best debt-to-income ratio is zero percent, not including debt related to your rent or mortgage. The less debt you have, the less of your money gets spent on interest payments and the less goes to pay off things you've already bought. This means you have more of your income left over to save or to spend however you wish.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.