Debt To Income Ratio
In todays world of debt, one of the terms you hear thrown around by lenders is your “debt to income ratio”. Simply put, this is a ratio that lenders use to know if you are borrowing too much and might have to choose to pay for food instead of choosing to pay them. If the ratio is too high, you are too high of a risk to lend to.
Add up all of your minimum monthly payments and divide it by your gross monthly income. So, for instance, say you have a $1500/month mortgage, $300/month car payment, $75/month on credit cars, and $200/month student loan payments and you make $70k/year. You have $2075/month in liabilities to pay for and $5833/month gross income. Based on accepted debt levels in society, you are fairly normal. You have a debt to income ration of 35.6% ($2075/5833). Generally speaking, banks do not like to give mortgages if you will end up with >43% ratio. (What is a debt-to-income ratio? Why is the 43% debt-to-income ratio important?)
Realize, that this is all on gross income. If you are part of the majority of this country that pays taxes (45% of Americans pay no federal income tax) then when you deduct 25% or so for taxes, then 43% worth of debt payments, you are left with only 1/3rd of your own money, which you still have to pay for things such as medical, dental, vision, and life insurance. If you are also trying to plan for your future and putting away the suggested 15% retirement. That 32% is likely now down to somewhere around 10-15% after retirement and insurance costs). Leaving you around $900/month for food, clothing, furniture, charity, kids activities, car repairs/maintenance/tires/gas, home repairs/upgrades, electricity, water, cable tv/internet, pet food and vet costs if you have a pet… all of the sudden, that $900/month could seem pretty slim. Which would make sense why most people are not saving 15% of their income for retirement. You make $75k/year… one would think you could afford things in life, the occasional baseball game, concert, vacation, etc… but the math shows a different story.
So, you can understand why 43% is a huge red flag to a lender. If you are approaching it already, it hopefully throws up some red flags to you as well.
Life To Income
If you live debt free, you have a debt to income ratio of 0%. Which means you likely live below your means and likely do not spend everything you make. You are likely not out there spending 55% of your gross income every month and are hopefully investing/saving a portion (large portion?!). So how much should you be spending each month? After all, you need some kind of life balance, you need to enjoy some of your hard work and money.
This is where I have come up with the concept of a “Life to Income Ratio”. How much do you spend on life as compared to what you make? In the same scenario above, making $75k/year, they have a 14.4% ($900/6250) Life to Income Ratio. But, when you have debt, you have little control over what that ratio will be. When you are debt free, it becomes a choice. The longer you live with a lower Life to Income Ratio, the more you can invest.
That same person making $75k/year could choose to have nearly a 75% Life to Income Ratio if they wanted, the other 25% will be going to Uncle Sam’s
KGB Extortion Ring IRS. They would be rolling pretty nicely with that high of a ratio, having over $4600/month to spend. Of course, this would come at the expense of saving for retirement and requiring them to work the rest of their lives to maintain this lifestyle.
It is highly unlikely you can maintain a 0% ratio, because you have to buy food at least once in your life. So what percentage is best? There is no one sum answer in my mind. What works for me might not be enough “life” for someone else or it might not be enough future savings for another person. It is a personal choice, but there is one truth that exists in the math; the longer you keep that ratio low, the more money you will have later. If you are investing the other ‘unused’ percentage, then your income will ultimately also increase and even if your Life to Income Ratio remains the same, your standard of living will increase due to it.
What Is My Life To Income Ratio?
For the past few months, I have been living on a 16.85% Life to Income Ratio. Which, after taxes, is leaving me with about 55% of my gross income to give and invest. I did not intentionally aim for a 16.85% ratio, but I was aiming for a 50% investment ratio and the Life to Income Ratio became a bi-product of that decision. My intent is now to maintain a 20% or less ratio for the next few years in order to maximize the amount I can invest. As my income increases, that same percentage will allow me to slowly increase my lifestyle and after a few years I may consider increasing my Life to Income Ratio up to 30%.
What is your Life to Income Ratio? I would love to know what you think of the concept in the comments and if it is something that might help you.