I’m a big fan of “knowing your financial numbers.” It’s natural to assume financial success based on income. However, financial success is not based on income alone. It’s a fact that high income doesn’t always mean you’re financially stable. Many high income earners are broke. This means net worth is negative. Your net worth is the value of what you own minus the amount you owe. You can read more about this in my blog post You CAN Become a Millionaire on an Average Income.
Debt to Income Ratio (DTI)
Another number that’s extremely important is your Debt to Income Ratio or DTI. It’s especially important if you plan on obtaining a mortgage for a home. You can’t get a loan if your DTI is too high.
In addition, DTI provides a snapshot of your spending habits and buying power. Once you complete the calculation you may realize why you feel like you’re living paycheck to paycheck (because you are!). You may realize why you can’t get your budget to work (because you’re spending more than you make!). You may realize you’re house poor or car poor or in other words, spending too much of your income on your house or cars.
Here’s how to calculate your Debt to Income Ratio (bank method):
First total your monthly debt payments which includes car loans, student loans, credit card payments, secondary housing debt or any other amounts you’re obligated to pay. This number should not include non-debt payments such as groceries, utilities, car insurance or entertainment. It should not include current rent payment or mortgage payment as it’s assumed you will be replacing these with a revised mortgage payment.
Then you divide the above number by your gross monthly income and this gives you your DTI ratio.
Make sure you use your gross income and NOT net take home pay.
Mr and Mrs Smith have a combined gross monthly income of $6,000.
They have the following monthly payments obligated by contractual debt: car payment 1 of $250; car payment 2 of $500; student loan of $200; credit card minimum payments of $400; personal loan payment of $150 making their total monthly debt payments $1,500.
Therefore, their DTI ratio is $1500/$6000 = 25%.
What does this mean?
Traditional lenders generally prefer a 36% DTI ratio, with no more than 28% of that debt dedicated to your mortgage payment (including taxes and insurance).
Prior to the credit crisis of 2008, the banks were getting loose and were allowing as high as 55% total debt to income ratio. The subprime mortgage crisis produced a market correction that revised these limits back down to 36%.
What does this mean for Mr and Mrs Smith from my example above? Regardless of their good credit score, they’ll not be able to get a conventional loan mortgage of more than $660 per month ($6000 gross monthly income X 36% = $2,160 minus current debt obligations of $1,500 =$660).
The bank’s DTI formula says that the couple could ultimately afford a mortgage payment of 1,680 (28% of $6,000). However, due to their current debt obligations, that won’t be possible because it would bring their DTI to 53%. If Mr and Mrs Smith would like a house with a mortgage payment of more than $660, they need to get rid of their expensive car and replace it with a used one. They should focus on revising their budget to get rid of their high credit card and personal loan debt. Ultimately and ideally, they’ll need to bring their current debt obligations down to 8% of their gross income which is $480 per month thus allowing them to get a mortgage for $1,680.
You can easily calculate your debt to income ratio through Zillow’s online calculator.
Kaz’s Advice (my improved DTI calculation)
I know I’m just another person but I can tell you why you should take my advice: 1) I’m not a bank trying to squeeze every bit of money out of you. 2) I’m a CPA and have worked in the finance field for nearly 25 years. 3) I’m 42 years old and have some life experience under my belt. I have made many money mistakes that I have learned from ?.
It’s good to know the banks are being (forced to be) a little more stringent than they were in the early 2000’s. However, I think the 28% DTI for a mortgage is still too high for two reasons.
First of all, everyone’s in a different tax bracket so I believe it’s a bit unrealistic to say everyone can afford a mortgage at 28% DTI, especially people in higher tax brackets.
Secondly and most critically, it enforces a trend Americans have gotten into over the past 40 years: low savings rate or none at all. When a bank says you can afford 28% of your gross pay in a house payment, it limits the amount of money you could be saving and then 15 to 30 years go by and you haven’t saved a dime towards your retirement or your kids’ college funds.
This is the crucial time to save for these two major life events. Your kids need college money at 18. It’s really unfortunate if your mortgage has you strapped and you can’t save for your kids’ college during that time, Don’t let your kids start their life in debt!
In addition, the earlier you contribute to retirement, the better, due to the compound interest of money. TIME is the best money-maker! Don’t think about retirement AFTER you’ve paid off your mortgage. By then, it’s too late.
With these two factors in mind, my rule is that your house payment should be no more than 25% of your take home pay. I’m a big believer in paying yourself FIRST. Take advantage of your employer’s retirement plan and put away 15% for your retirement. The benefit of this is that it’s pre-tax money and therefore lowers your taxable income. You can read more about this in my post on What You Need to Know About Your 401(k) or 403(b).
Let’s use Mr and Mrs Smith as an example. They make $72,000 a year which puts them in the 15% tax bracket with an effective tax rate of 14%. Let’s assume they have 18% deducted in medicare, social security, state and local taxes and benefits. If we use the bank method of 28% DTI for their mortgage and assume they have gotten their total monthly debts down to $480, it leaves them with $443 per week for groceries, utilities, entertainment, car insurance and savings. Of course we know groceries, car insurance and utilities should come first. Using weekly averages: groceries $160, utilities $115 and car insurance $20 therefore leaving $148 for entertainment, incidentals, retirement savings and kids’ college savings. Incidentals and entertainment happen next especially when you have kids and a house to maintain. Now they have no money left for savings.
If Mr and Mrs Smith take my advice, they would first put away 12% into their pre-tax retirement plan. Both of their employers match 3% so they would be taking advantage of the match and would be saving $10,800 annually (total of 15%).
We would use the same percentages in taxes and benefits with a slight decrease in fed tax due to the deferred retirement income. This brings their take home pay down to $42,000 or $3,500 per month. However, I would not include the 12% retirement deferral in the 25% calculation which means they should have a house payment of $1,055 or less ($3,500 true take home pay plus $720 for the 12% deferral = $4,220 times 25%).
I would assume they still have 8% in other debts plus the same amount in groceries, utilities and insurance. Therefore, they would have $158 each week to use for incidentals, entertainment, kids’ college savings and other savings goals. They’re able to live within their means while paying themselves first because they didn’t get a mortgage more than they could afford.
In summary, the bank says they can afford $1,680 for a mortgage (28% of gross pay) with $148 left per week and most likely no savings.
I’m saying they can afford $1,055 for a mortgage (25% of take home pay) with $158 left per week AFTER saving for retirement.
If they started putting away $10,800 annually at age 25, they would have over a million dollars at the age of 55 (assuming no annual increases and a conservative 7% interest rate).
I digress to prove my point that listening to the bank is not always in your best interest (no pun intended)?. They are out to take your money as the additional interest paid is going to them. I’m saying you should pay yourself first and budget less for your home. This interest then goes in your pocket, not the bank’s.
Maybe you would rather have a larger home and no retirement savings? You should ask yourself why you want a larger home. Is it worth not paying yourself first? Right now it may seem so but when you get closer to retirement age, your perspective on life changes. You may regret not saving enough for retirement. Social security will NOT be enough to comfortably live on. Maybe you plan on working until you die?
I challenge you to calculate your DTI regardless of whether you want to get a mortgage or if you already have one. Ideally your DTI (including housing) should be less than 37%. If your DTI is higher than that you should read Dave Ramsey’s book, The Total Money Makeover to help you get your finances on track.