Why a Debt-to-Income Ratio Should Be Based on Monthly Payments
We have been talking lately about debt-to-income ratios (DTIs) and how they serve as good indicators of overall financial health. We recently covered the question of “What is a good debt-to-income-ratio, anyway?” and discussed some ways you can improve it. And while we did show that calculating your debt to income ratio is simple (it’s even easier with our calculator), we now need to clarify the difference between looking at your dti on a monthly and annual basis.
Understanding the Formula
When the debt-to-income ratio formula is described, it’s often explained as simply, “Divide total debt by total income.” What’s often left out is the explanation of why doing this on a monthly basis will lead to a more accurate calculation. Let’s dig deeper.
To make it through this we are going to need to do some math. We can start by building a profile for a hypothetical consumer. Let’s imagine that she has an annual income of $40,000 and the following debts and balances:
Now, we will also want to get an idea of the minimum monthly payments she is facing:
And, her monthly income:
$40,000/12 = $3,333
Using Annual Figures
Let’s take a look at her debt-to-income ratio, starting with an annual approach. So, we take her total debt of $10,950 and divide it by her annual income of $40,000. The result? A debt-to-income ratio of 27 percent, which as we know is a dangerous level.
Doesn’t that seem a little high? While our hypothetical client does have some credit card debt, right now it doesn’t look all that bad. Really, the bulk of the debt is tied to a student loan, which is fairly low risk compared to high-interest accounts. Not only that, but a $10,000 student loan debt total is fairly small, considering the average graduate has closer to $25,000.
Maybe we should try a different approach.
Using Monthly Payments
If we take a look at her monthly debt-to-income ratio, we might get a much clearer sense of her overall financial standing.
If we add up the monthly payments listed above, we see that her monthly debt total sits at $150, and her income is $3,333. Using our formula, this results in a dti of 4.5 percent. Wow! That’s a huge difference.
So what’s going on here?
The reason for this large discrepancy is that debt repayment is not typically based on an annual schedule. The student loan is the best example of this. That loan will not be paid off until 10 years have passed. So, that monthly payment of $115 will be made 120 times! Essentially, if we try to box the full $10,000 balance into an annual dti, we are going to skew it by an extra nine years. It just doesn’t add up.
Here’s another perspective: If we take the monthly income of $3,333 and multiply it by 12, we get $40,000. We expected this, because that is our annual income in this example. But what about the debts? If we multiply $115 by 12, we get $1,380, which is the total of the student loan payments after one year. But this falls far short of the full $10,000 amount. Even the credit cards don’t add up. If we multiply $20 by 12, we get $240, which again falls short of the balance—$800.
Make the Correct Calculations Moving Forward
We haven’t come up with anything earth-shattering here, but we hope that we have clarified how you should properly calculate your debt-to-income ratio. Be sure to use monthly figures, because they will give the most balanced and realistic perspective. If for any reason you have issues, be sure to check out our debt-to-income ratio calculator. And, if you struggle with a high dti of above 15 percent, consider a free budget and credit counseling session.
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