You may have heard or read from financial advisers and other blogs that your monthly rent/mortgage payments should be less than 30% of your monthly net income. This is great advice!
Before you fall in love with the home or apartment and begin to sign the paperwork, you’ve got to make sure you can afford the monthly payments. Like I mentioned in a previous post, the debt to income ratio is an extremely important number that lenders look to when they decide whether you qualify for a mortgage or not. So, my advice to you is take a page from their book and keep an eye on this ratio yourself.
Your debt to income ratio gives you insight on how much money is committed to paying to monthly debt obligations, including rent/mortgage. To give you a personal example, my mortgage payments and HOA fees is 16% of our monthly net income. It’s below the recommended 30% because my wife and I choose to live below our means, since our priority is to become debt free ASAP. But when you take a closer look at our debt to income ratio, we are at 30.99%, which includes student loan payments, mortgage + HOA fees, and our auto payments. By looking at our finances from this perspective, we’ve been able to make decisions that help us manage our debts and our cash comfortably and effectively.
Therefore, you should apply this same strategy when you begin your home search. Between rent/mortgage and other debt obligations, such as credit cards, student loans, and auto payments; your total debt to income ratio should remain below 40%. Anything above this poses high risks and you’re most likely living on tight cash flow.
Take a look at this image below which I’ve borrowed from BetterMoneyHabits.com. It’s the perfect graph to illustrate how your monthly budget should not contain more than 40% of debt obligations (even though I just realized this example has debt payments at 41%, but it’s close enough).
The last thing you want to do is to take on rent that you will struggle to pay. Or, perhaps you can pay it but you will probably be in a situation where you’re literally working to just pay your rent and you can’t even enjoy a nice dinner or a movie night. Don’t put yourself in these situations. Make the decision to live below your means so that you can set yourself up for long term success from a financial stand point. My wife and I have adjusted plenty of times and we’ve never looked back.
So, if you’re asking yourself, “OK I get it, but how can I reduce my debt to income ratio?” What I’m about to say is super simple and it can be easier said than done, but it’s not impossible! Basically, you’ve got 4 methods…
- Make more money. By earning more income, you will reduce the ratio percentage and more of your money can be spent on other things in life and you’ll be able to save more!
- Don’t keep adding debt. If your debt to income ratio is flirting around the 40% range or is above it, the first thing you need to do is stop adding more debt. Stay true to your budget and focus on bringing down your debt as fast as possible.
- Priority #1: Pay off your debts. I know, it’s silly to say this because it’s common sense but I can’t complete this post without it. If you’re unable to earn extra cash, make sure that you are not adding more debt and that you’re paying it down as aggressively as possible.
- Cut costs. Find ways to cut your costs. As a personally example, I stopped using Uber Eats, buying coffee, and when I cut my cable TV and I’m saving $2,300/year! The cash from these savings can be used to pay down your debts and reduce your debt to income ratio!
The bottom line is that you want to make sure you’ve got full control of your money and, most importantly, that you are making the best decisions. By being able to understand what your debt to income ratio is, you’re looking at your finances from a different perspective. This way of thinking will force you to consciously set benchmarks for your financial life and you’ll learn how to adjust, like moving into a smaller apartment, getting a roommate so you can split the rent, or by simply cutting your costs.
Debt to Income (DTI) Ratio Formula
Monthly debt payments / Monthly income = Debt to Income Ratio