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The debt to income ratio is a simple comparison of income generated in a specified period to the amount of debt that must be honored during the same period. Usually, a debt to income ratio is calculated for a one-month period, providing a snapshot of what must be earned in order to pay monthly obligations. Debt to income ratios are helpful in determining how much additional debt can be assumed without creating financial hardship.
Understanding the relationship between debt and income is helpful in several different ways. For people attempting to develop a workable monthly budget, it is important to identify all current obligations and what type of monthly payment is required to keep the debts in good standing with creditors. For lenders, getting a true picture of the ratio of debt to income makes it possible to evaluate the ability of a borrower to assume additional debt.
There are actually two distinct forms of debt to income ratio. The first is known as front end or high debt to ratio. This ratio involves comparing monthly gross income to monthly housing expenses. While not a total picture of monthly debt obligations, this approach does demonstrate whether the borrower can continue to afford housing if an additional loan obligation is added to the mix.
Back end or low debt to income ratios focus on adding all fixed monthly expenses to come up with the total monthly obligations and comparing the total to the amount of monthly gross income. Along with basic housing obligations, such debts as monthly child support, health insurance payments, credit card payments, and alimony payments are also taken into consideration. This approach to determining the true financial status of the borrower provides a clearer idea of the total current debt load and provides the lender with a better idea of how much risk is involved with extending the loan.
It is important to note that calculating a debt to income ratio will always include any obligations that show up on a credit report. This means existing loans and other fixed monthly expenses will be present. However, variable expenses are not likely to be listed on a credit report and thus must be revealed by the borrower.
Lenders also tend to set a percentage range for the relationship between debt and income. When the debt to income ratio calculator indicates the front end ratio is no more than 35% of gross income and the back end ratio is no more than half of the gross income, the borrower is usually considered a good risk. However, if the debt to income ratio is higher than 50%, lenders may turn down the loan application.
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