Your Debt-to-Income (DTI) is one of the most important numbers you can know if you want to determine your overall debt health and understand how lenders view you. But you need to know how to customize this metric for your circumstances or you could be setting yourself up for trouble.
In finance, lenders use the “3 C’s of lending” that define whether or not a loan is a good one to make: Creditworthiness, Capacity, and Collateral. Creditworthiness is usually determined by your credit score, which really only measures how likely you are to continue making payments based on your past behavior. Capacity is how much you can afford to pay based on your income and is usually measured by Debt-to-Income (DTI). Collateral is whether or not the loan is backed by a physical asset (like your home or car) that can be claimed in case of a default to minimize losses.
Debt-to-Income is used by nearly all mortgage lenders and many installment lenders for auto and personal loans. DTI measures your current debt payments relative to your pre-tax income under the relatively straightforward idea that the more of your income is obligated to pay debt each month the less capable you are of taking on more debt. At some point, you’ll become so “maxed out” that you are truly at risk of being unable to make all your payments.
Lenders calculate your DTI in two ways: front end DTI (housing) and back end DTI (total).
looks only at your housing costs relative to your income. If you own a home, this will be your mortgage payment, taxes, insurance, and HOA fees. If you just rent, it’s your rent payment. Lenders like to see less than 28% of your income going to housing payments.
Back-End DTI: looks at your housing expense plus other legal and debt commitments like credit cards, auto loan or leases, personal debt, medical debt, and legal obligations like child support and alimony. Lenders like to see less than 36% of your income going to total debt and legal payments.
Most of us have heard some of these terms before and the idea that as long as your personal metrics are below the target levels that you’re “healthy”. But it’s important to remember that banks view DTI as a measure of how much debt payment you can support on your income and that’s a very, very different question from “how much debt should I have given my life stage and goals?”
To assess your debt health, think about your debt fits into your situation and goals. Obviously, a person with only a few years to go until retirement should have most if not all of his debt paid off to be able to enjoy a comfortable retirement. At SavvyMoney, we generally recommend that people pay off all their consumer debt by time they turn 50 and that they look to pay off their mortgage before they retire. Doing so will help you accumulate retirement assets before you retire and stretch those assets further into retirement.
Good luck, and stay healthy!