By Carshon Rodgers, financial advisor at LPLFinancial
Moving out on your own for the first time can be very exciting. Finally, the freedom to go where you want, when you want! But gaining that independence comes with adult responsibilities, specifically when it comes to living within a budget. What does that mean? In the simplest terms, it means being aware of your income versus your expenses—basically, the amount of money you earn versus the amount of money you spend.
You may think that as long as you are able to pay the minimum amount due on your bills each month, you are financially secure and living within your means. However, there is a bigger picture to consider, especially if you want to borrow money to make a major purchase such as a car or a home.
When you apply for a loan with a bank or other financial institution, the lender will look at how much you make and how much you owe, but it won’t consider your circumstances or your character—the lender will be looking for specific numbers.
The first guideline the lender will consider is your debt-to-income ratio. Simply stated, this is a comparison of the money you bring in versus the obligations you have to pay out.
Lenders do not look at all of your expenses to calculate your debt; for example, they don’t consider your day-to-day spending on gas, food, cable, Internet, phone, gym, entertainment, clothes, or any of the other things you might consider essential to your lifestyle. For the debt-to-income ratio, lenders only look at big obligations—such as credit card debt, student loans, auto loans, and personal loans—that you likely are paying off in increments over a period of time.
Most lenders want to see that these debts are no more than 36 percent of your total gross income.
What might that look like? Click through the slideshow to find out:
[Any reference to a specific company, commercial product, process, or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education, Carshon Rodgers, or LPL Financial. This material was created by NEFE and is not affiliated with or endorsed by LPL Financial.]
Debt to Income Ratio
- Let’s assume a young couple makes $60,000 a year between the two of them.
- Multiply the couple’s income by 36 percent and you get $21,600 in debt payments per year ($1,800 a month). This is the amount at which lenders would like to see the couple limit its debt payments. This does not mean that the couple has only $21,600 in debt, but that their debt payments for the year do not exceed that amount.
- The next thing a lender wants to see is that your total living expenses—such as rent, heat, electricity, and any other payments related to keeping your home going—amount to 28 percent of your total gross income.
- Most mortgage lenders will use this 28 percent as a guideline to determine if you are eligible for a mortgage loan (and how big of a loan you qualify for).
Let’s take the same couple making $60,000 per year ($5,000/month).
- Twenty-eight percent of the couple’s gross annual income is $16,800.
- Divide that by 12 and you get $1,400 per month.
- If the couple limits its spending on living expenses (rent and utilities) to $1,400 per month, that keeps them within the 28-percent living expenses guideline. On the same note, the couple’s mortgage loan payment should be no more than $1,400 to stay within that guideline.
- Now, subtract this $1,400 from the total debt-to-income calculation of $1,800 per month.
- That leaves the couple $400 a month to spend on other debts.
What might that look like?
- The couple has $400 to pay for recurring debts such as student loans, a car payment, and credit card debt.
- Let’s say they each have student loans with a monthly payment of $100.
- This would bring the couple down to $200.
- Let’s also assume the couple has a car payment of $200 per month.
- That brings the couple right up to the 36 percent debt-to-income guideline.
- If the couple has any additional loans or credit card debt, its debt-to-income ratio will be higher than the ideal 36 percent.
What do you do with the money left over?
If you are able to live within the above guidelines, you will still have money left over. So, what should you do with it?
These guidelines are based on your gross income, which means that you will have to factor in deductions—for taxes and benefits such as health insurance, workplace giving programs, and 401(k)—that come straight out of your paycheck.
You likely will put the rest of the leftover money toward other expenses such as your phone bill, groceries, gas, and fun stuff like shopping and going to the movies. But you want to consider these things only after you’ve paid all your mandatory obligations. And, keep in mind that you also should factor savings into your monthly budget. And, although I realize this may be difficult when you’re first starting out, be sure to increase your savings as your income increases.
What if you can’t make these numbers work?
If your debt-to-income ratio is higher than 36 percent, it doesn’t necessarily mean that you can’t get a loan. Remember, these are just guidelines.
One option for getting a loan when your debt-to-income ratio is higher than the lenders’ ideal is to find a co-signer. After finishing school and landing my first job, I had two student loans and a credit card balance. Since it was my first job, my income was low and my debt-to-income score was higher than 36 percent. I needed a good car to get to my new job, but I couldn’t afford to buy one without a loan. Fortunately, my father offered to co-sign with me, and I was able to get approved. Once I started making more money, I was able to have his name removed from the loan.
Even if you don’t have a co-signer, lenders may still extend you credit if your debt-to-income ratio is higher than 36 percent, but you may be subject to a higher interest rate.
So, take some time to calculate your own numbers and see where you could make some changes to your budget. It’s a step in the right direction toward a healthy financial future!